Investment Psychology: Meaning and Types of Psychological Biases

Investment can be a tricky business, given the various economic factors and market dynamics you need to keep in mind before arriving at a decision. In the previous modules, we explored the nitty-gritty of assets, loans, credit cards, insurance, and ways to minimise risk while maximising returns. However, we didn’t talk about how the complexity of the human brain can play a pivotal role in investment. 

Psychological biases exist in all human beings, and they creep in unconsciously, impacting your investment choices and leading to outcomes that are different from what you expected. Cognitive biases, which involve decision-making based on conventions rather than facts, often pave the way for erroneous judgements. In other words, they drive you to deviate from rationality and create a subjective reality instead of focusing on the objective information available around you. 

So, let’s dive deep into a cognitive biases list and understand how each affects your investment psychology.  

Types of Biases That Can Impact Investment Outcomes

Below are the bias types that can impact the returns on your investments

Overconfidence Bias 

If you are an overconfident investor, you might have a propensity to overestimate your knowledge or capabilities, which can drive you to undertake more risk than is right for you. This is because you might feel that you can predict market movements with absolute accuracy. However, investing in too many high-risk assets can be a rash move and lead to significant losses. 

Anchoring Bias 

This type of bias occurs when you believe excessively in the first piece of information that comes your way. You end up using that information as a reference point or anchor for subsequent data inputs. 

For example, anchoring bias can lead you to make investment decisions based on only the current price of a stock. You might ignore the stock’s trading history and the fact that prices change regularly. 

Anchoring bias can prevent you from critically estimating an investment’s true potential. Instead, you might end up with unrealistically pessimistic or optimistic expectations which cannot be realised.  

Loss Aversion 

Most investors care more about preventing losses rather than reaping profits, which means they hold on to investments that are bound to lose in the hopes of recuperating the losses someday. Loss aversion can also push investors to take on too little risk when in reality, undertaking slightly more risk might prove to be profitable. 

Or they might stick to one or just a couple of assets that are deemed completely or mostly safe instead of diversifying their portfolio. A lack of diversification can negatively impact the portfolio’s performance and prevent investors from earning higher returns.   

Fear of Missing Out (FOMO) 

FOMO is a kind of psychological bias where an investor feels they are missing out on a positive investment opportunity that others are vested in. It can lead to anxiety or fear and cause the investor to make choices that are suboptimal and not led by a rational strategy. 

They might:

• Chase a specific asset that has witnessed major gains recently and buy it at high prices without in-depth analysis
• Make rash decisions without understanding an asset’s fundamentals
• Ignore possible risks as they are too driven by the appeal of possible gains
• Mimic what others are doing instead of assessing an investment on their own 

Herd Mentality / Groupthink 

Herd mentality and groupthink are similar psychological biases that primarily involve investors who go along with the opinions or behaviours of a group and ignore independent, critical analysis. These biases can not only lead to erroneous choices but also impact market dynamics negatively. Let’s delve deeper. 

Herd Mentality  

• Investors are prone to follow the majority, especially in uncertain scenarios, thereby causing widespread purchase or sale of an asset.
• Investors might purchase assets experiencing an upward momentum out of fear of missing out on promising opportunities that others are enjoying. 
• Herd behaviour can exaggerate market trends and cause erratic price movements that are based on the crowd’s actions instead of the asset’s fundamentals. 
• Investors are deeply affected by the news, which exaggerates market movements. While negative news might lead to a panic sale, positive news can prompt excess purchases.

Groupthink  

• Investors avoid disagreeing with the group’s opinions and focus on consensus.
• Investors discourage the expression of alternate views even if they offer valuable perspectives. 
• Investors bank on collective judgement and ignore individual scrutiny of the asset.
• Groupthink leads to underestimation of risk, which might incur heavy losses. 

Confirmation Bias 

In this case, investors stick to pre-existing opinions and beliefs and look for information that confirms the same. They tend to ignore any piece of information that contradicts their beliefs. For example, confirmation bias can make you lean towards analysis or news that complements your pessimistic or optimistic point of view on a stock or trend. Naturally, this can narrow your perspective and drive you to make decisions that are not as profitable as you think them to be or highly risky.   

Recency Bias 

Investors with recency bias assign more weightage or importance to recent trends and events, driven by the assumption that the present conditions will continue. In other words, such investors tend to overlook historical patterns and long-term fundamentals. This means they react strongly to market movements in the short term. 

Here’s an example for more clarity. Mutual funds are a type of investment that has been recently trending in our country. They are often considered more promising than insurance plans. However, if you have a recency bias, you will likely ignore the fact that both mutual funds and insurance plans like ULIPs depend on market performance. You might also ignore the emergency cover offered by insurance plans or other long-term assured benefits. 

Hindsight Bias 

Investors with hindsight bias deem that past events could have been more predictable after they have already happened. Essentially, they think they could have predicted past market movements with more accuracy. And this makes such investors excessively confident about future predictions. They ignore the uncertainties and complications that were present before an event occurred, which in turn hampers their ability to make rational and informed decisions in the future. 

Familiarity Bias 

This is one of those types of biassed psychology where investors prefer to invest in industries and assets that are familiar to them. In the process, they ignore unfamiliar options even if they promise better returns or greater portfolio diversification. It is somewhat similar to confirmation bias, where investors seek information that aligns with their pre-existing notions. 

Self-Attribution Bias 

Also known as self-serving bias, it is a scenario where investors attribute gainful outcomes to their own skills and abilities and adverse outcomes to external factors. Such a bias makes the investor feel less accountable for erratic choices and soothes their ego or self-esteem. It also builds overconfidence in choices that lead to positive outcomes, thereby skewing future investment strategies.  

Hence, identifying these psychological biases and managing them consciously is crucial if you want to make well-informed and logical decisions that go with your financial goals and risk tolerance. Let’s find out how you can inculcate a rational and systematic approach towards investment. 

Building a Disciplined and Rational Investment Approach 

Here are the key factors to keep in mind to keep the biases at bay while building an investment approach that truly helps you to profit and accumulate wealth while controlling risk: 

• Chalk out investment goals. Whether you are looking to fund your child’s higher education, travel the world, or save up for retirement. 
• Objectively assess your tolerance towards risk, which means you need to figure out how much potential loss and volatility you can bear comfortably. 
• Avoid putting all your eggs in one basket by diversifying your investment portfolio. By diversifying, you can spread investments across multiple types of assets like bonds, stocks, commodities, real estate, and more. Since you won’t be relying on any one market or investment, it will be easier to manage risk. 
• Think long-term if you wish to build wealth. Try not to respond to market fluctuations in the short term. Long-term investment can not only compound returns but also even outweigh market volatility. 
• Research investment assets carefully before investing in them. Don’t just look at their historical price trends. Focus on the fundamentals, too, like the issuing company’s financial health and growth potential in the case of a stock. Look into possible risks and market conditions as well. 
• Devise a well-defined investment strategy based on your research, objectives, and risk tolerance. You can pick a particular style of investing (like income, growth, value, dividend, etc.) or adopt a mix. List down the possible actions you will undertake as and when market conditions change. 
• Keep the various psychological biases discussed above in mind and control them mindfully so that your decisions are not driven by greed, fear, anxiety, or past beliefs. During market fluctuations, avoid being impulsive or taking a cue from what other investors are doing. 
• Review your investment strategy and portfolio periodically and tweak it if necessary. With time, your goals and risk tolerance might evolve, and hence, adjusting asset allocations and revising the portfolio might be essential.  
• Always stay updated on market conditions, economic trends, global events, and so on, as they can affect your investments and future decisions. 
• Keep track of the costs and fees associated with different investments. Losing sight of the same can impact your returns negatively. Try to pick cost-effective investment options that align with your risk profile. 
• Learn important lessons from successful as well as unsuccessful investment decisions. Analyse which strategies worked and which ones failed so you can improve your future approach. 
• Consult an investment or financial advisor if you need expert guidance. 

Wrapping Up

In this module, we learned about different types of bias psychology and their impact on your investment. We also covered the basics of crafting a rational and balanced approach towards investment.  

In the next module, we will dive into another crucial aspect of smart investment – financial fraud and ways to stay protected against the same.