The biggest risk for investors isn't the market, but their own minds, biases and emotions often lead to poor financial choices.
In their book Mastering Personal Investments: 20 Steps to Financial Independence, Prasanna Chandra and Savita Shrimal explore the hidden biases that cloud financial judgement.
They argue that investors often sabotage themselves not because of markets, but because of their own psychology.
Read on for a fascinating excerpt from Mastering Personal Investments: 20 Steps to Financial Independence:
Check Your Irrationality
The investor's chief enemy lies within: Benjamin Graham
As human beings we are endowed with certain characteristics of mind and behaviour that lead to imperfect decisions and even dreadfully serious mistakes.
Often, we are not rational and do not act in our own best interests.
We must guard ourselves against the following behavioural biases and influences which can impair our investment decisions:
1. Overconfidence
Overconfidence is the unwarranted faith in one’s intuitive reasoning, judgments, and cognitive abilities.
This leads investors to an illusion of control, underestimation of risk, and overestimation of returns.
It is one of the most potent causes of investor mistakes. For instance, investors may believe they can successfully time the market, identify mispriced stocks, or hold excessive concentration in one asset because they 'know better'.
2. Representativeness
Representativeness is the tendency to judge the probability of an event by finding a 'comparable known' event and assuming that the probabilities will be similar.
Investors often rely on stereotypes and fail to consider the actual base rate. For example, they may assume that because a company has performed well in the past, it will continue to do so, ignoring changing fundamentals.
3. Loss Aversion
Loss aversion is the tendency to prefer avoiding losses rather than acquiring equivalent gains.
The pain of losing Rs 100 is psychologically more powerful than the pleasure of gaining Rs 100.
This often leads investors to hold on to losing investments too long, hoping they will bounce back, while selling winning investments too quickly to 'lock in' gains.
4. Herd Instincts and Overreaction
Investors tend to follow the crowd, assuming that if everyone is buying or selling, it must be the right thing to do. This herd behaviour can create asset bubbles and crashes.
Overreaction occurs when investors place too much weight on recent events, expecting trends to continue indefinitely, rather than recognising them as temporary fluctuations.
5. Innumeracy
Many investors have poor mathematical skills and struggle to grasp probabilities, risk, and statistical concepts.
This innumeracy leads to misjudgements, such as underestimating compounding, misinterpreting diversification benefits, or failing to calculate the real impact of fees on long-term returns.
6. Mental Accounting
Mental accounting is the tendency to treat money differently depending on its source, intended use, or mental category, rather than considering it as part of a whole.
For instance, an investor may splurge a tax refund while being frugal with salary income, or take excessive risks with 'bonus money' but act conservatively with 'savings'.
Such compartmentalisation leads to suboptimal financial decisions.
7. Narrow Framing
Narrow framing is the tendency to make decisions without considering all the implications, treating each choice in isolation rather than part of a bigger picture.
An investor may evaluate a single stock on its own merit without considering how it fits within the broader portfolio. This results in insufficient diversification and heightened risk exposure.
8. Anchoring Bias
Anchoring is the tendency to rely too heavily on the first piece of information encountered when making decisions.
Investors may anchor to a stock's purchase price, refusing to sell below it even when fundamentals have deteriorated. Or they may anchor to past index highs, expecting the market to 'return' to that level regardless of changing conditions.
9. Story Bias
Human beings love stories. We tend to impose narratives on events, even when they are random or unrelated.
Investors may favour a company because of a compelling success story in the media, ignoring hard data.
Story bias often leads to chasing 'hot stocks' or investment fads based on a persuasive narrative rather than solid fundamentals.
10. Illusion of Understanding
People believe they understand the past, and therefore think they can predict and control the future.
Investors often overestimate the role of skill and underestimate the role of chance in outcomes.
This illusion of understanding creates overconfidence and encourages risky behaviour.
11. Confirmation Bias
Confirmation bias is the tendency to seek, interpret, and remember information that confirms our existing beliefs, while ignoring contradictory evidence.
An investor bullish on a stock will highlight positive analyst reports and dismiss negative ones, reinforcing their initial stance and blinding themselves to risks.
These behavioural traps illustrate why the investor's worst enemy often lies within.
To build financial independence, one must recognise and counteract these biases. Rational, disciplined investing requires resisting the pull of emotion, narrative, and herd mentality.
The key is to adopt systematic processes, diversify broadly, and focus on long-term goals rather than short-term market noise.
Checking one's irrationality is not easy, but it is essential for sustainable wealth creation and security.
Excerpted from Mastering Personal Investments -- 20 Steps to Financial Independence by Prasanna Chandra and Savita Shrimal, with the kind permission of the publisher, Bloomsbury.
Disclaimer: This article is meant for information purposes only. This article and information do not constitute a distribution, an endorsement, an investment advice, an offer to buy or sell or the solicitation of an offer to buy or sell any securities/schemes or any other financial products/investment products mentioned in this article to influence the opinion or behaviour of the investors/recipients.
Any use of the information/any investment and investment related decisions of the investors/recipients are at their sole discretion and risk. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Opinions expressed herein are subject to change without notice.
Feature Presentation: Rajesh Alva/Rediff