Behavioral Bias: Cognitive Versus Emotional Bias in Investing

"Everybody has biases. We make judgments about people, opportunities, government policies and, of course, the markets. When we analyze our world without knowing about these biases, we put our observations through a number of filters manufactured by our experiences, and we're not just talking about stock screeners.

We're talking about the filters we put our decisions through that sometimes make them biased. Day-to-day activities are primarily driven by behavioral patterns. The same behavioral patterns also guide investing actions.

It’s impossible to be unbiased in our decision-making. However, we can mitigate those biases by identifying and creating trading and investing rules – but only if we know what to look for."

Read more here.

Behavioural biases that affect investment success

An interesting topic came up for discussion during a recent family lunch. Electric vehicles - and how they were going to bring a paradigm shift not only for passenger and goods transportation but also for the oil industry.

The logic went like this: Global warming is being caused by auto emissions. Oil resources are getting depleted. Alternative bio-fuel experiments haven't worked. Electric vehicles are the obvious viable and environment-friendly solution.

Prices of electric cars are high because of lack of volumes. Batteries need to be recharged after travelling fairly short distances. But battery technology is improving. Vehicle prices will fall as demand increases.

A few years back, wind turbine maker Suzlon came out with its IPO. Wind power was touted as the future of energy. Investors piled into the stock and lost their shirts. Why? 

Oil prices came down from well above the $100 mark to $40. Wind power was no longer the talk of the town. It didn't help that Suzlon's technology was faulty.

Aren't these classic cases of judgement influenced by what happened or was heard in the recent past?

Investing success requires a planned and dispassionate approach. Emotions like greed, fear, euphoria, despondency lead to poor decisions. Buying or shorting a huge quantity of stock on 'gut-feel' can lead to disastrous consequences.  

The study of behavioural finance enables us to be aware of some of the common emotional and cognitive biases that affect decision making, like:

1. Anchoring
2. Confirmation
3. Loss aversion
4. Disposition effect
5. Hindsight
6. Familiarity
7. Self attribution
8. Trend chasing

Learn more about these behavioural biases from the following article:
8 Common Biases that impact Investment Decisions

Does your Investment Style fit your Personality?

To be a successful investor, you must have your own investment style. That means evolving a system that works for you - by figuring out your own strengths and weaknesses and keeping a record of your successes and failures.

Every person has personality traits, cognitive biases, eccentricities, habits that affect their decision making. If you are impulsive, you may buy 5000 shares of Opto Circuits at Rs 9 and hope to double your investment in 3 months.

If you are risk averse, you may be happy with the long-term returns you get from a monthly SIP in an index fund or a balanced fund. 

An investor below the age of 30 may invest all her monthly savings into an equity fund. An investor who has already celebrated his 50th birthday may prefer the safety of bank fixed deposits or a debt fund.

According to an article published by the CFA Institute, there are four types of Investor Personalities:

1. Preservers - loss averse and deliberate in decision making, they are more keen to preserve their existing wealth than indulge in risky investments in search of rapid growth. They often end up not taking any decision at all and miss money-making opportunities.

2. Followers - not much interested or skilled in the investment process, they end up following the advice of friends or colleagues and have a portfolio full of yesterday's winners.

3. Accumulators - may have tasted success in a business enterprise or career, giving them the confidence to actively manage their own investment portfolio. They like to win big, and often make large risky bets that can lead to big losses.

4. Independents - like to think 'out of the box' and play contrarian based on their own research. They usually follow a plan and are not as over-confident as Accumulators. But relying too much on their own research can be time consuming and counter-productive.

So, which of these four Investor Personalities fit you the best? Give it some thought (if you haven't done so before) and then decide what kind of investment style you should follow. Your investment success will depend on it.

Read more from this investopedia.com article.  

How price ‘anchoring’ can hurt stock market returns

Price ‘anchoring’ is a cognitive bias. That means, your mind tends to play tricks with you at certain price points. You tend to take decisions based on perceptions or gut feelings that are often illogical.

Next time you visit a shoe shop, take a close look at the price tags on different shoe models. You will come across price tags of Rs 399 or Rs 999 or Rs 1499 or Rs 2999. Is the shop owner trying to fool you?

The answer is: Yes. Apparently, the number 99 has a strange effect on the mind. You know it is less than a 100, and that is some how very effective in closing a sale!

How does this bias work in the stock market? Here are three examples.

1) You have received a ‘tip’ about a bargain stock from a friend and decide to enter it at a price of Rs 32. It had touched a high of Rs 50 a couple of weeks back, but had corrected since then. Your friend says it can’t go any lower.

As often happens, the stock continues its correction after you buy. You wait for a month or two, but the stock fails to cross above Rs 25. You decide to hold on to get back your ‘buy price’. The stock moves up to Rs 28 – but you refuse to sell.

You get ‘anchored’ to your ‘buy price’. Only you know about this price. The market doesn’t, nor does it care. The stock falls below Rs 10 and stays there for the next 3 years. You finally sell it at Rs 6.

2) You do a decent amount of research and prepare a short list of stocks you wish to buy. You start tracking the stocks regularly. You are particularly keen on a stock that moved from Rs 50 to Rs 100, but is hovering around the Rs 85 level.

Finally, the stock dips to Rs 75 and you jump in to buy a decent quantity. You decide to be smart, and sell half your holdings when the stock hits Rs 150. The balance of your holding would then become ‘free of cost’.

Clever strategy – except that the stock refuses to move past Rs 135. You keep holding, but the stock drops to Rs 120. So, you hold some more – and it rises to Rs 135 again. But your mind is ‘anchored’ to Rs 150, and you don’t sell.

After a while (and by this time 2 years may have gone by), the stock drops to Rs 100. You sell off – happy to make a 33% profit on your ‘buy price’. But you lost out on a chance to make 80% profit by not selling at Rs 135.

3) You decide to enter the NBFC segment and short-list a stock trading at Rs 70. The company is a subsidiary of a well-known engineering giant. You decide to get a confirmation from an analyst friend before entering.

The friend suggests a different stock belonging to a less known business house that is trading at Rs 900. But your mind gets ‘anchored’ to the ‘cheaper’ price because Rs 70 is much less than Rs 900.

You think, with limited resources, you can only buy 30 shares at Rs 900. But you can buy 400 shares for Rs 70. So, you ignore your friend’s advice and buy the Rs 70 stock.

What you fail to realise is that the Rs 70 stock is actually not ‘cheap’ at all, because it is trading at a high P/E of 44; whereas, the more ‘expensive’ Rs 900 stock is trading at a much lower P/E of 16.

Sound familiar? It should. Most small investors end up making such errors in decision making due to their cognitive bias. (Yours truly is no exception. Been there, done that.)

The trick to making money in the stock market is to learn from your mistakes by documenting them and not repeating them.

Are you susceptible to the ‘backfire effect’?

Before I explain what the ‘backfire effect’ is (please be reassured that it has nothing to do with a badly tuned two or four wheeler) and why you should or should not be susceptible to it, please allow me a little digression.

Before I started writing this blog more than 4 years back, I used to be a regular visitor and participant in various online investment groups. My altruistic objective was to leverage more than 2 decades of investing experience to spread knowledge and awareness among young, novice investors.

The bull run was continuing unabated, and most discussions in various investment groups were about unknown or questionable companies whose stock prices had already zoomed up to unreasonable levels.

Since this was a tell-tale sign of a bull market nearing its peak, I cautioned investors by posting contrary fundamental and technical opinions about some of the companies being discussed. Surprisingly, most responses to my posts ranged from the indignant (“I will buy more if the stock price falls”) to the downright offensive (“Don’t spread stupid rumours”).

In one of the groups, I had posted in Oct ‘07 that the Sensex was looking extremely overbought technically and investors should book profits. In those days, many small investors were unconvinced about the efficacy of technical analysis. Many still are.

There was a hue and cry among group members and I was banned from the group for my heresy. It opened my eyes, and taught me that it is very difficult to convince some one in an argument if a strong opinion has already been formed.

That brings me to the ‘backfire effect’, that most human beings are susceptible to and can prove disastrous in investing. This is how Wikipedia describes it: (It) is a cognitive bias that causes individuals challenged with evidence contradictory to their beliefs to reject the evidence and instead become an even firmer supporter of the initial belief.

In a recent discussion in an investment group, the topic of discussion was a tea producing company that had entered into an agreement with an overseas company for training and maintenance of flight simulators, and had also launched a chain of ‘kebab’ outlets. I questioned the di’worse’ification because of the lack of synergy between the three businesses.

I shouldn’t have bothered. The response was predictable. The investor who had initiated the thread posted that he loved di’worse’ified companies, and would add more to his substantial holdings if the stock price dropped. A classic case of the ‘backfire effect’!

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