The Princeton University psychologist Daniel Kahneman, who recently passed away at the age of 90, is the pioneer in behavioural economics and won a Nobel Prize for his work which established a relation between psychology and economics.
The Prospect theory, the work for which Kahneman won the Nobel Prize, proposed a change to the way humans make decisions while facing risks, especially those related to investments.
Amos Tversky and Daniel Kahneman conducted a series of psychological experiments and found that investors value gains and losses differently, placing more weight on perceived gains versus perceived losses.
For the exact same amount, investors feel the impact of losses much more than gains.
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Example: If one is given a choice between receiving Rs 500 and a 50% chance of winning Rs 1,000, the first option is likely to be chosen even though the expected value of both options is exactly the same.
Why does this matter?
The overwhelming fear of losses can cause investors to behave irrationally and make bad decisions. Once you are aware of a bias, you are better equipped to make a rational decision.
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Let us look at some practical examples of biases when it comes to investing and apply the timeless lessons taught by Daniel Kahneman.
Example 1: Timing the market
The market is like a complex mechanism that is influenced by various macro & micro-economic parameters. Trying to predict where it would go next is a futile exercise however investors often try to predict the markets in the hope of increasing profits.
The Herd Mentality Bias refers to an investors tendency to follow and copy what other investors are doing. They are largely influenced by emotion and instinct rather than their own independent analysis.
A 23-year study of Nifty showed that if you missed 43 days out of the total 5950 days your investment would give a 1.15x return but if you invested and did nothing it would give a 12.7x return.
The chance that you will be able to catch those outlier positive returns is very low as their frequency of occurrence itself is low ~ 0.72 percent in 23 years.
Example 2: Investing only in the brands you use
Just because a brand is popular or that you use it in your daily life does not mean that it will make you a profit on your investments.
The Familiarity Bias is a phenomenon in which people tend to prefer familiar options over unfamiliar ones, even when the unfamiliar options may be objectively better.
When people encounter familiar options, they are more likely to experience cognitive ease, which can make those options seem more appealing.
To avoid familiarity bias, it is important to carefully evaluate all options, including unfamiliar ones, and to consider their relative metrics rather than relying solely on familiarity.
Example 3: Picking mutual funds based on 1 year returns
While selecting funds or investment strategies, investors often look at the recent performance and get influenced by these numbers. However, this may not be the right approach as there are several other parameters that need to be assessed while choosing investment products.
The Recency Bias is a cognitive bias in which people favour recent events over historic ones. This gives an illusion that a similar event is likely to occur in the near future as well.
To tackle this bias especially while picking mutual funds investors must consider several parameters like rolling Sharpe ratio, downside capture ratio, maximum drawdown, consistency of performance over a long-term period. Recent returns and point estimates could be misleading.
Example 4: Holding on to loss making stocks
Investors often hold on to loss making investments in the hope that losses will recover in the future. This is because booking a loss is emotionally a much heavier task than booking profit.
The Loss Aversion bias refers to a phenomenon where a potential loss is perceived by individuals as psychologically more severe than an equivalent gain.
This could be avoided by having a systematic approach in place when it comes to investing. At the time of making any investment, write down the things that could go against that decision and keep an appropriate stop loss in place.
To reduce the impact of the loss, find a better replacement to the loss making stock and transfer those funds to the better opportunity. This would then reduce the feeling of booking a loss as you are merely transferring the investment from one to another.
Example 5: Falling trap to quick money making schemes
“Get 5 percent monthly returns consistently”.
“Double your money by investing in crypto currencies”.
Such statements paint a bright picture in the mind of investors as it frames their mind according to what they want to hear.
The Framing Effect is a bias in which our decisions are influenced by the way information is presented. Equivalent information can be more or less attractive depending on what features are highlighted.
Example: Consumers tend to prefer labels “90% fat-free” over those labelled “only 10% fat” when essentially both are the same.
When an investment sounds too good to be true it probably is very risky. Consider the past risk, potential losses and costs of such investments to understand the full picture instead of falling trap to attractive statements.
Daniel Kahneman illustrates many such biases in his book ‘Thinking Fast & Slow’ which is one of the most influential books of all time. He was indeed one of the most distinguished personalities of this century and his teachings will remain with us forever.
Rohan Borawake is Co-Founder & CEO, Sabir Jana is Co-Founder and Head of Quantitative Research, at FinSharpe Investment Advisors. Views are personal, and do not represent the stand of this publication.
Rohan Borawake is Co-Founder & CEO at FinSharpe Investment Advisors. Views are personal, and do not represent the stand of this publication.
Sabir Jana is Co-Founder and Head of Quantitative Research, at FinSharpe Investment Advisors. Views are personal, and do not represent the stand of this publication.
