Chapter 15 - Behavioural Biases and Common Pitfalls in Investment – Part 2

Prem and Sachin are seasoned stock market investors. They keenly follow the market and have been investing for a long time.

Prem continued to wait, believing the stock price would return to Rs. 700. But unfortunately, despite trade market analysts and financial experts sending out red signals regarding the company's prospects, Prem held onto his belief and eventually suffered a significant loss.

Prem fell prey to what we commonly call anchoring bias.

Behavioural bias#4: Anchoring bias

Anchoring bias is a common erroneous belief held by all kinds of investors, even the experienced ones.

This is when you are unwilling to sell stocks at prices lower than their purchase cost. The purchase price of the stock works like an anchor. You may believe that the company will bounce back to the original purchase price if it is trailing. And so would be unwilling to change your decision. So, anchoring bias basically the tendency of being influenced by a reference point or a number.

What can you do about it?

When investing in the stock market, it is vital to acknowledge errors and correct them. You see, the market dynamics are constantly changing. So, it’s important to consider the rapid pace of the stock market and factor in new information from credible sources to make the right decision.

Behavioural bias#5: Gambler's fallacy

Here’s a conversation between Ashish and his friend Keval about the stock he chose to invest in a few days back.

Here, Ashish assumed that it wouldn't fall any further since the stock had already fallen by 40%.

This is another common bias among some investors, especially new ones.

In this bias, you may believe since the stock price has already fallen to a considerable level, wouldn't fall any further without credible backing on why you think so.

What can you do about it? 

If you have substantial reasons, backed by financial analysts and experts as well as your own research, that the price will not fall any further, you can make the right decision. However, if the stock price falls by 40 to 50%, it is no guarantee that it will not lose any further.

Behavioural bias#6: Availability bias

"It's best to stay away from the stock market. I know so many of my friends who have lost money investing in shares, so why should I risk it?"

This is not the first time you may have heard such statements. It is a simple example of availability bias.

But what is availability bias? 

It is a human tendency to believe and misjudge an event on its frequency and magnitude that may have taken place recently. Sometimes you tend to make decisions based on information you receive without researching or finding out the trustworthy source behind it.

This form of bias applies to many decision-making events and is not just limited to investments.

What can you do about it?

When taking an investment decision, consider all rational options available to you. Assess the pros and cons and its outcomes to find the right choice. When it comes to investing, weighing in the risks and rewards associated with the investment type as well as your risk profile is an important factor to look into that can help you make the right investment decision.

Summary

• Anchoring bias is the tendency of being influenced by a reference point or a number.
• Gambler's fallacy, also known as the Monte Carlo fallacy, is when investors believe that since the stock price has already fallen to a considerable level wouldn't fall any further without credible backing on why you think so.
• Availability bias is a human tendency to believe and misjudge an event without looking deeply into it.

In the next chapter, we will cover the remaining behavioural biases and help you understand how they can impact your investments.

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