Financial goals, asset allocation and discipline are considered to be the three pillars of investment success. However investors are humans and will, from time to time, be guided by their emotions rather than rational thinking. Making investment decisions on emotional urges can cause a lot of harm to the financial interests of the investors. It is important for financial planners to go beyond their traditional areas of expertise e.g. goal planning, investment and insurance planning, tax planning etc, and apply behavioural finance in their practice, so that they are able to help investors in making prudent financial decisions. Behavioural finance is an area of study which explores the impact of human psychology on investor’s behaviour and decision making.
Emotional biases in investing
Decision making by investors are influenced by certain emotional biases. The extent of these biases will differ from investor to investor and situations. Some of the common emotional biases are as follows:-
- Herd mentality: Herd mentality is following what other investors are doing instead of following a financial plan. Fear of missing out (FOMO) is typical characteristic of herd mentality. If many of your friends are investing in a hot Initial Public Offering (IPO), you do not want to left behind and subscribe to the IPO, without any research or knowledge about the stock. Herd mentality leads to asset bubbles which can lead to large losses when the bubble bursts. The dotcom bubble in the late 90s was example of herd mentality in action.
- Loss aversion: Loss aversion is refers to an investor’s preference to avoid a loss. You should distinguish between loss aversion and risk aversion, even though both may seem similar. A risk-averse investor prefers to invest in low risk assets. A loss-averse investor, on the other hand, may have high risk appetite. Loss aversion leads investors to hold on to hold on loss making stocks or funds for a long time because they do not want to sell their shares or mutual fund units at a loss. This leads to low return on investment. It can also lead to investors selling stocks or funds at a much bigger loss than what they would have incurred if they sold earlier.
- Confirmation bias: Investors often make decisions based on their opinions without checking if their opinions are correct. For example, I give you the 4 cards shown below. Each card has an alphabet on one side and a number on the other side. I tell you that “there will always be an even number on the other side of a vowel”. You do not know, whether my statement is true or false. What will you do? If you believe in my statement, you are likely to pickup card with A or 4 printed on the front, and check if there is an even number or vowel on the other side. Suppose you pickup A and find that there is an even number on the other side, does it prove that my statement is correct? No, because the card with 4 printed on it may have a consonant on the other side. Instead if you picked the card printed with K on the front and found an even number on the other side, you could conclusively prove that my statement is wrong. Confirmation bias leads to you to look for information that supports your opinion and ignore information that contradicts it. For example, if you believe that midcaps are very risky, you will only recall the periods when midcaps had deep corrections e.g. 2008, 2012, 2018, 2020 etc to confirm your belief and ignore the periods when midcaps outperformed. Confirmation bias leads to overconfidence about your investment strategy and can harm your financial interests in the long term.
- Availability bias: This refers to making investment decisions based on thoughts that come to your mind first or what you can recall easily, rather than taking all factors into consideration. For example, if investors were asked how the stock market performed in 2020 during the COVID-19 pandemic, many investors would say that the Nifty fell by 37%. The stock market crash due to the outbreak of the pandemic is easy to recall. However, if you look at the full year performance of Nifty in 2020, the index rose by 15% year or year. Investors remember the crash and not the rebound, because the crash was dramatic while the rebound was more gradual. Availability bias causes you to lose objectivity and make wrong investment decisions, which harm your financial interests.
- Recency bias: Recency bias is a type of availability bias, where you give more importance to short term performance than long term performance. For example, an investor put Rs 100,000 in a mutual fund 5 years back. The market value of his investment grew to Rs 200,000 and in the last three months, it fell to Rs 150,000. If you ask him about the performance of his fund, he may say that he lost Rs 50,000 in 3 months. This is recency bias. Recency bias can prevent investors from investing when market has bottomed resulting in opportunity losses.
- Mental accounting: Mental accounting is perceived utilities of money from different sources. Spending your salary on credit card debt and taking a lavish vacation with your bonus is an example of mental accounting. You could have repaid your debt with your bonus, but mental accounting prevents you from doing so because you think bonus is meant for discretionary spending. Another example of mental accounting is treating tax refund as a gift to be enjoyed for discretionary spending. The utility of money is the same, irrespective of its source. For example, if you are saving a part of your salary for your long term financial goals, you should save part of your bonus for your financial goals. Most investors do not know that they have mental accounting bias and continue to make wrong financial decisions.
How can financial planners help investors overcome emotional biases?
Financial planners must realize that investors may not always stick to their financial plans due to these emotional biases. Therefore sustained engagement will be required on part of financial planners to help investors overcome emotional biases. Financial planners can help investors in the following ways:-
- Help investors understand how market works. Equity markets always work in cycles. There will be periods when prices go up (bull market) followed by periods when prices fall (bear market). Markets will eventually recover from the lows and goes on to make new peaks.
- You need to reinforce this message to the investor both in bull and bear phases, not just when the investor is redeeming. This will prevent the investor from over-extending in bull markets and panic selling in bear markets.
- Focus on asset allocation. Asset allocation will balance risk and returns. It will reduce your investors’ portfolio volatility and provide a more stable investment experience. Your investor’s asset allocation will depend on his / her risk appetite. You need to assess your investor’s risk appetite and provide him appropriate asset allocation guidance.
- Negate herd mentality and other emotional biases through regular asset allocation rebalancing. When markets are high, rebalance from equity to fixed income and vice versa, with the objective of maintaining the target asset allocation of the investor.
- Maintain a portfolio approach instead of focusing too much on performance of individual schemes. Some schemes may outperform / underperform in different market phases. Portfolio approach will help you negate availability bias.
- Increase your engagement with investors in bear markets or deep corrections. This is the phase where the investor is more susceptible to emotional biases and need guidance / handholding. This is a difficult phase, but an advisor who is able to build stronger engagement with investor in this phase builds stronger relationships.
- Regular financial plan reviews. You should review the financial plan of your investors, including progress against different financial goals on a regular basis. This will help your investor remain disciplined towards his / her financial goals.
