Behavioural Finance is understanding how our beliefs, emotions, and psychological makeup affect our decisions with money. It is a very fascinating segment and often not given a lot of importance. Money means different things to all of us. And while we want to be as rational as possible while dealing with it, often our past experiences and beliefs influence the decisions we make. Those decisions may or may not be rational according to traditional wisdom, but it is the choice we make. There are a few common biases and fallacies of behavioural finance which we often fall into. Let’s decode a few of them and understand how to avoid them.
Herding is an extremely common occurrence not just in finance but also in various aspects of life. We buy the stocks which are ‘hot property’ and because ‘everyone seems to be buying them’ While in the short turn it may be beneficial as it may introduce you to new ideas, but in the long run it’s bound to lead to a downfall. The reason is that when you harvest a herding mentality, you may enter an idea, but don’t have conviction around it. And when difficult times arise, it invariably leads you to exit the markets. Avoid herding mentality by building your conviction. While not going after the herd may lead you to have FOMO, going after the herd and it not ending well could lead to actual, tangible pain in the terms of capital loss. Be your decision-maker. Always.
The next big fallacy is Narrative Fallacy. As humans, we love stories, We are conditioned to react to emotions and words. They appeal to our senses. However, several times, good stories lead us to neglect the cold hard evidence in terms of the numbers. A stock may have a great growth story, but buying it at monumental valuations is risk just not worth undertaking. Listen to the stories. Act on evidence. Don’t let the lure of a fantastical future ignore the realities of today.
This is a bias even the best of investors suffer from. It is human nature to believe in the law of averages. When a stock has gone up, we feel at some point it will come down. A stock that has given losses, there is an intuition that it will have a turnaround. Being loss aversive we cut off our winners prematurely because we fear losing out on the small profits we have made. To flourish in the markets it is important to not fall into this bias. Let your winners run the course and cut off your losers.
Anchoring bias is as prevalent in finance as in our lives. Anchoring means relying a lot on information received initially. This bias prevents us from changing our opinions and acting on new developments. If we see a stock at $100, invariably if we see another stock at $75, it seems cheaper to us without evaluating other aspects. Anchors like the price don’t reflect the intrinsic value and in the long run, could prove to be a reason for distress. Carry out your analysis, be open to changes and try to keep biases of price and other vanity metrics aside.