# Herd Mentality : Humans, by their nature, are socially inclined and have fear of being left out. This same fear is applicable to investing. Investors tend to follow market trends blindly and invest in fear of being left out, without checking their relevance with their financial goals.
This bias is known as ‘ herd mentality’.
#Attention Bias: When investors tend to invest in financial products which are frequently highlighted ( say, in newspapers ), without analyzing its suitability any further, it is known as ‘ attention bias’.
This can also translate into investing in products which are well-known to investors, thereby limiting the return potential of their investments.
This is known as ‘ familiarity bias’.
# Confirmation Bias : Investors tend to seek out information or opinions that support their preconceived notions about investments.
They tend to turn a blind eye towards information that does not support their opinions.
This is known as ‘ confirmation bias’.
# Optimism Bias : Some investors tend to be overtly positive about their finances, with or without substantial actions and/or information to support the outlook, thereby underestimating investment risks. This is known as ‘optimism bias’.
This bias, in turn, often translates into ‘ overconfidence’ , where investors overestimate their investing abilities.
# Recency Bias : Sometimes investors invest continuously in instruments that have performed well in the recent past, with the mistaken assumption that good historical performances automatically imply good future performances as well.
This is known as ‘ recency bias’.
# Loss Aversion Bias : Many investors primarily invest to avoid losses rather than to gain returns on their investments.
This bias is known as ‘loss aversion’. With this bias, investors tend to hold on to unprofitable investments, or invest in instruments having low return potential.
This reluctance to sell off unprofitable investments can also stem from the tendency to avoid the feeling of regret experienced from making poor investment decisions. This is known as ‘ regret avoidance’ bias.
Adopt strategies to make investment decisions free from bias :
Few of these strategies can be —
à Planning asset allocation before investing
à Reviewing and rebalancing one’s portfolio periodically
à Doing systematic investments/ transfers/ withdrawals
à Establishing ground rules to limit losses
à Taking help from professional advisors
What is Mental Accounting ?
It shows how individuals separate their budget into different accounts for specific purposes.
Mental Accounting and Investments:
Example 1 : People also tend to experience mental accounting bias in investing. When it comes to investing, mental accounting can also cause people to make illogical decisions.Investors invest their wealth based on the source of income. Higher weightage is given to hard earned money like salary as investors usually prefer to take lower risk while investing their salary income. An investor who is young should ideally have a higher portion of his/her wealth in equities. However, since there is a emotional attachment to hard earned money; he may not be willing to invest a larger portion of his salary income in equities (as equities are perceived as risky asset class ). The same investor when faced with windfall gains tend to take higher risk with that amount.
Salary Income : à Invest in safe assets
à Pain of loss is greater
Windfall Gains : à Take risks by speculating
àDon’t mind loosing money
Example 2 : Investment with a Loss
Value of money remains the same for an investment made on the advice of a distributor or through own research. However, when evaluating a loss making investment, investors tend to hold on to the same forever if the initial decision to buy was that of the investor himself/herself ( as booking a loss hurts his ego). The emotion of regret is in play here. On the other hand, if the initial decision to buy the investment was as per the recommendation of another person, say, the advisor, the investor would be willing to sell the asset at some point and move on. This decision to sell is taken at the cost of diversification.
To avoid the mental accounting bias, individuals should treat money as perfectly fungible when they allocate among different accounts, be it a budget account (everyday living expenses), a discretionary spending account, or a wealth account ( savings and investments). But it is easier said than done.
Example 3: Overspending on credit card rather than cash
More impulsive buying on a shopping trip could be attributed to the use of credit cards as compared to giving away cash. However,’ money’ is ‘ money’.
Example 4 : Tax Refunds
Tendency to treat tax refunds as a windfall gain and use it for discretionary spending.
Asset allocation is Key to Financial Success :
–> Asset Allocation helps overcome emotional attachment to inherited assets.
à Each asset class has a different Return-Risk-Liquidity profile
à Diversification is needed to achieve optimal balance between rewards and risks
à Asset allocation decision is the most important factor for long-term wealth building
à There is no “ one size fits all “ formula for asset allocation. One needs to take professional help during this important step of financial planning
You are what your deepest desire is. As is your desire, so is your intention.As is your intention,so is your will. As is your will, so is your deed. As is your deed, so is your destiny.—Upanishads
Take up one idea.Make that one idea your life—think of it, dream it,live on that idea.Let the brain,muscles,nerves,every part of your body, be full of that idea,and just leave every other idea alone.This is the way to success.—Swami Vivekananda
Someone’s sitting in the shade today because someone planted a tree a long time ago.—-Warren Buffett
Compound interest is the eighth wonder of the world.He who understands it, earns it he who doesn’t pays it.—Albert Einstein
Bull markets are born on pessimism,grow on skepticism,peak on optimism and die on euphoria.—-Sir John Templeton
