As a young investor, you are sure of your capability to earn good money & investing it in the right avenues. However, you must be mindful that most of your decisions come from your feelings & emotions as human beings.
Certain behavioral biases can lead you to make wrong decisions which can negatively affect your financial health. The more you are mindful of these biases, the more logical & rational financial decisions you can make.
In this post, we share the top 5 biases that every young investor should be mindful of while making investment decisions.
Bias # 1: Herd Mentality
Bias # 2: Loss aversion
If you plan to watch a movie or eat out on the weekend, you check with your family & friends for recommendations & go ahead with it, isn’t it? Well, that is herd mentality for you, simple.
Being part of the herd makes the mind feel safe.
You don’t know whether the path is right or wrong. But you derive a sense of satisfaction from being part of the crowd rather than being seen as someone who walks a lonely path.
This behavior is acceptable only till it is limited to things casual like movies and restaurants. But not when it comes to managing your money. You may end up making money decisions that don’t serve your financial needs & goals.
To avoid herd mentality bias:
- Spend time learning about personal finance.
- Do your own financial research.
- Arrive at an informed opinion basis your unique financial situation.
Bias # 3: Recency:
Scientific research has proven the fact that the pain of loss is twice the joy of gain. And this is why people commit the following costly financial mistakes:
- Selling investments when markets start to fall.
- Holding on to poor investments.
- Forego wealth-creating asset class like equity for fear of loss.
To avoid loss aversion bias:
- Know that high returns accompany higher risk. For your long-term goals, be prepared to invest in equity. For risk, manage it through a proper asset allocation process.
- When markets tank, consider this as a SALE. You get to pick up quality stocks for fewer prices. This goes to reduce your overall cost of investment.
- Do not get attached to your investments. Set a loss limit on your investments. Follow it ruthlessly.
Bias # 4: Confirmation:
Recency bias means that an investor gets highly influenced by the information/events in the recent past. And he/she uses this information to make investment decisions.
For example, during rising equity markets, investors try to join the party on reading about the returns that people around them are earning. The sad part is that it’s done at the cost of their financial goals, risk tolerance, and asset allocation. Result: As and when markets fall, these investors suffer the maximum loss.
To avoid recency bias:
- Limit your intake of market news – Do not track markets daily.
- Always follow a “process” when it comes to your finances.
- When it comes to making a new investment, evaluate from all angles – risk, return, taxability etc.
- Stay away from hot stock tips or “flavour of the season” mutual funds.
- Invest systematically in equity schemes (through SIP) with a proven long term track record, & regardless of the market levels.
Bias # 5: Self-Attribution:
When you invest your hard-earned money, your decision should be backed up with hard facts. However, studies have proved that investors generally rely on emotion to decide on the investment. And then, they apply logic to justify the decision.
For example, you’ve made up your mind to invest in a so-&-so stock. Before investing, you look at its Price to Earnings ratio (PE ratio) & find it very high. Plus, you find that it has a lot of debt on its balance sheet. You know that the debt can impact its long-term earnings.
To justify your decision, you compare its PE with other companies in the sector. You find its PE to be within the range. And hence you go ahead with your decision. So, here your confirmation bias led you to ignore the fundamentals & selecting a poor-quality stock.
To avoid confirmation bias:
- Carry out research on the investment through multiple sources before making any investment
- Be open to critical feedback
- Hire a financial planner to give you an unbiased second opinion on your finances.
This bias means that as an investor, you take credit for sound financial decisions to your financial acumen. Whereas in case of any loss, you blame the markets, economy, and everything.
Suppose you invest in equity mutual funds. By coincidence, around the same time, the markets start to rise. You see yourself earning an excellent double-digit return. While you go about bragging about your achievement, remember that markets are volatile in the short term & the tide can turn anytime.
To avoid this bias:
- Dive deep into learning the fundamentals of personal finance such as asset allocation, rupee-cost averaging, compounding, etc.
- Set ground rules & process & let that process guide your financial journey
- Take yourself out of the equation. Stick to the process.
Investing is a long and slow journey. Think of it like a marathon, not a 100m dash. Be prepared for the ups & downs, which will test your resolve and temperament. In the end, only one who keeps a steady head in tough times & avoids the various behavioral biases that will win the race.