Now, let us discuss the different types of behavioural biases that affect the stock market participants. They are as follows -
It is said that investors are more affected by losses than by gains, even if both are of the same quantum. This causes them to hold on to losing stock positions in the hopes of breaking even. They do not realise the opportunity cost of the invested amount which could be invested elsewhere to earn is much more than the amount lost in the other trade. Loss Aversion bias leads to risk aversion by investors as well as they prefer to play safe.
This is an emotional bias wherein investors have too much confidence (more than necessary) on their skill, strategy, analysis, et cetera. This causes them to not hedge their risk properly, take stock exposures bigger than their capacity, keep holding on to losing stock positions, not selling at the right time with profits and a multitude of such scenarios. I have often found this bias to be more prevalent in new participants. Most new participants enter the market in the bull run when they see everybody around them is making money by trading in the markets. So, but obvious, they also make money initially and that leads to generation of overconfidence bias. It is imperative to understand that many times, your losses and gains are just a market phenomenon and have nothing to do with your skill or strategy.
“If everyone is doing it, it must be right!” - This is the mindset of many, not only in the stock market but in life in general. And this is the mindset that had led to the birth of the dotcom bubble, housing bubble, Japanese bubble economy and several other such historic bubbles. One must always act on individual faith and research in the stock market, otherwise it is very easy to get wiped out by this tsunami.
Investors often use an arbitrary number or some information as anchor for subsequent judgements and decisions. Owing to this, they do not adjust to new information adequately. In my example of SRF earlier, I sold it at ₹3725 and turned that number into an “anchor point”. I refused to buy the stock at a higher price even though there was positive news about the company and its business as I kept hoping for the stock to revert to this anchor.
It is like using a shortcut when one uses easily available information or even preconceived notions to make judgements and trading decisions. The most common example is that of mutual funds which are heavily advertised. Just because they are heavily advertised, they become more recallable to an investor and they tend to falsely believe that the particular fund is also the best option from an investing point of view.
It is easy to identify the source of an event after the event has occurred. However, this identification often deludes traders into thinking that they have “predictive powers” and that this identification could have been done in the past too. After every crash or rally, you often hear people saying that “Of Course this was going to happen” but in reality, the same reasons do not seem that obvious at the time of taking action.
Putting more weightage or giving more importance to the “recent” events before taking a trading decision is a result of Recency Effect. For example, the announcement of a merger can take precedence over the firm’s track history in conducting business.
Confirmation and Cognitive Dissonance Bias
Every human is born with an ego and even in the stock market, they want to be right every time. As a result, they only look for information that confirms their pre-existing belief and choose to ignore new information which challenges their belief. This results in lack of responsiveness and adaptation by a trader. Cognitive dissonance has a similar outcome but it doesn’t stem from ego or from the need to be correct but because humans don’t want to go through the psychological distress of dissonance by accepting information that proves them wrong. This is what I was personally experiencing when I tried to “average down” my SAIL position.
Status Quo Bias
Status quo essentially means that the person is resistant to change and doesn’t want his present state/position/situation to be modified in any way. This again causes people to not adapt to new information or accept that their previous beliefs were wrong. It results in holding losses for too long and also missing the opportunity to sell and make substantial gains.
This bias is like a free rider in a group project. When something goes right, they come forward to attribute the success to themselves and when things go wrong, they take two steps back blaming others for the failure. This bias causes one to ignore his mistakes and not learn from them, in a way, it prevents the growth of a trader as he will continue to repeat his mistakes. Traders suffering from self-attribution bias also tend to take too much risk and hold overly concentrated portfolios.
This is when an investor puts more value to something when they own it as compared to when they don’t. As a result, investors often avoid selling a stock either due to emotional attachment with it or the belief that it will provide superior returns (which may or may not be true). This also prevents investors from researching alternative investment opportunities.