Let’s do a thought experiment:
There is a runaway trolley barrelling down the railway tracks. Ahead, on the tracks, there are five people tied up and unable to move. The trolley is headed straight for them. You are standing some distance off in the train yard, next to a lever. If you pull this lever, the trolley will switch to a different set of tracks. However, you notice that there is one person on the side track. You have two options:
- Do nothing, and the trolley kills the five people on the main track.
- Pull the lever, diverting the trolley onto the side track where it will kill one person.
You have no other option. You must either pull the lever, or do nothing. No other elements are at play.
What would you do?
Almost all will prefer option one i.e. pull the lever and save effectively four lives. Seems fair, right?
Let’s take the experiment forward and consider another scenario:
Say, instead of standing beside a switch, you’re standing on a raised platform directly above the tracks, behind a rather fat man. The trolley is headed toward five people tied to the track. It is certain that, should you push the fat man, the trolley will stop. Should you do nothing, five people will die.
Does this change your answer?
It will for many …
Even though the math remains the same – one life for five. Further, in both the cases, you are performing an action that effectively takes away one life but the second option (pushing the man off the platform) engages brain regions associated with emotions while impersonal dilemma (like diverting the trolley by flipping a switch) engages regions associated with controlled reasoning.
This indicates that human mind’s decision-making process is a super-complicated one. The process gets affected by which part of the brain gets influenced by the way any information is presented, steps required to make a decision and many other factors. Furthermore, the end result of the process may not always be most optimal which is contrary to the traditional financial models and economic theory which assumes that individuals act rationally and make decisions efficiently.
Behavioural finance is the branch which challenges these assumptions and says that individuals are affected by biases and the actual behaviour may not always be rational. These biases are known as behavioural biases and controlling these biases is a very critical part of investment process for all the investors.
Below, we have mentioned five very commonly found behavioural biases in investors:
- Confirmation bias: Humans have a tendency to seek information that confirms their existing beliefs. For instance, if someone has an opinion that HDFC is a good stock to buy, it is very likely the investor will read more reports that support this hypothesis and in turn provide a “feel good” factor. Any reports to the contrary might be treated with some amount of doubt or even disdain. Outside of investment world, in our day to day life also, its anecdotally observed people watch media channels or read publications which support their political opinions. This again is a classic case of confirmation bias in play. This bias prevents any feedback mechanism leading to adverse decisions.
- Hindsight bias: This refers to “I always knew that this stock is going to rise” moment. An individual might have a positive view on let’s say twenty different stocks. One or two years down the line if say four of these stocks do well the individual may start overestimating the accuracy of his own predictions. This often happens because one tends to remember the right calls and blocks from memory the wrong decisions. One of the best ways to correct hindsight bias is to keep a written note of the calls or views so that selective recollection is not there.
- Loss aversion bias: It is often observed that investors are not “risk averse” rather they are “loss averse” – in fact they are fine taking on more risk to prevent or reduce an existing loss. This is commonly observed when investors “average out” a loss-making investment in the hope that with reduced average cost price they would not have to incur a loss. This over time can lead to bad investments getting accumulated in the portfolio or the concentration of a bad investment increasing with time.
As Daniel Crosby said “The irony of obsessive loss aversion is that our worst fears become realized in our attempts to manage them.”
- Herd Instinct: Humans are wired to find comfort in crowd since risk of being singled out is minimal. This bias is quite often seen in fund managers who at times invest basis their peers. In case of any bad investment call the repercussions get limited to a certain extent since their performance is not worse off than peers. This bias has also been attributed to lead to asset bubbles. The dot com bubble of late 1990s is an example of this. Most dotcom companies did not have sound business models, but many investors bought into them because everyone else was buying into them. Fear of missing out can also lead to this behaviour – one may buy a stock because couple of office colleagues bought it and one does not want to miss out on potential profits..!
- Hot hand fallacy: Humans have an extraordinary talent for detecting patterns and when they find them, they believe in their validity even though the pattern might have occurred out of chaos with no significant parameter driving it. For example, we all know that if a coin is tossed there is equal probability of a heads or tails coming. However, if a coin continuously produces heads thrice in a row (statistically speaking such an event will occur on average in one out of eight cases) one may start believing that chances of occurrence of heads in higher in the next attempt. Similarly, many investors may invest in a stock which has hit upper circuit for three days thinking that the trend will continue without comparing the current market price to its intrinsic value – often such investors end up buying these stocks at their peak leading to heavy losses.
The best way to tackle these behavioural biases is to first recognise the fact that each of us is vulnerable to them. So, one needs to make adjustments in investment process to account for them. For example, actively reading reports which are contrary to your investment opinions and challenge your beliefs is a way to avoid confirmation bias.
Afterall, we all need to realise:
“Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.” ~ Benjamin Graham