Behavioural Finance: Are you biased while investing?
Updated: Nov 14, 2019
There are two types of biases in investing: Cognitive and Emotional
Cognitive biases generally involve decision making based on established concepts that may or may not be accurate. The most common types of cognitive biases are:
1. Confirmation Bias:
Example- I feel like the stock price of XYZ Ltd will go up. I will only search for positive news that confirms my viewpoint.
2. Gamblers’ Fallacy:
Example- The stock price of XYZ Ltd has hit its all time low, it can only go up from here!
3. Status-Quo Bias:
Example- Every month I invest Rs 5000 in mutual funds. I will not look to change that because I’m comfortable with the current scenario.
4. Risk-Averse Bias:
Example- I will put my money in a fixed deposit instead of investing in stocks as my returns are more certain even though they may be lower.
5. Bandwagon Effect:
Example- Everyone is investing in mutual funds, so I will invest in mutual funds as well.
Emotional biases typically occur spontaneously based on the personal feelings of an individual at the time a decision is made. They may also be deeply rooted in personal experiences that also influence decision making. The most common types of emotional biases are:
1. Loss-Aversion Bias:
Example- I will choose an investment with a guaranteed return of 0% over an investment that returns 10% or -10% with an equal probability.
2. Overconfidence Bias:
Example- I have performed a detailed analysis of XYZ Ltd’s stock and collected data from 10 reliable sources, therefore I cannot go wrong in my call.
3. Endowment Bias:
Example- I am willing to sell shares of XYZ Ltd that I have for Rs 100 but I am willing to buy shares of XYZ Ltd for Rs 90
Both cognitive and emotional biases may or may not prove to be successful when influencing a decision.