Benchmark Investments

According to conventional financial theory, the world and its participants are rational human Being and strive to maximize their wealth prudently. However, there are many instances where Emotion and psychology influence our decisions, causing us to behave in unpredictable or Irrational ways.Simon Savage, co-head of European and global long/short strategies at GLG Partners, a hedge fund manager owned by Man Group, said:

“We were all born to be bad fund managers because of inbuilt behavioural biases, which are present in everyone to various degrees. It’s through an awareness of them that as a fund manager you can begin to build a defense mechanism to avoid these vulnerabilities. Ignore them at your peril.”

Here are some of the main behavioural biases that investors need to look out for:

Loss-aversion bias:

Loss aversion refers to investor's tendency to strongly prefer avoiding losses to acquiring gains. The fear of loss leads to inaction. Studies show that the pain of loss is twice as strong as the pleasure of gain of a similar magnitude. Investors prefer to do nothing despite information and analysis favoring a particular action that in the mind of the Investor may lead to a loss. Holding on to losing stocks, avoiding riskier asset classes like equity when there is a lot of information and discussions going around on market volatility are manifestations of this bias. In such situations, investors tend to frequently evaluate their portfolio’s performance, and any short-term loss seen in the portfolio makes inaction their preferred strategy.

Confirmation bias:

Confirmation bias is the phenomenon that describes the tendency of people to prefer information that validates their theses, hypotheses and beliefs independently of its truthfulness.

Confirmation bias, also called my side bias, is the tendency to search for, interpret, or prioritize information in a way that confirms one's beliefs or hypotheses. It is a type of cognitive bias and a systematic error of inductive reasoning.

For example, when a trader buys a stock for a reason and that reason doesn’t work out so the trader makes up another one for owning the position. Similarly, first we make decision in mind and then find for the Information to justify that intuitive decision.

Ownership bias:

Things owned by us appear most valuable to us. Sometimes known as the endowment effect, it reflects the tendency to place a higher value on a position than others would. It can cause investors to hold positions they would themselves not buy at the current level.

Gambler’s fallacy:

Predicting absolutely random events on the basis of what happened in the past or making trends when there exists none. It is the mistaken belief that if something happens more frequently than normal during some period, then it will happen less frequently in the future, or that if something happens less frequently than normal during some period, then it will happen more frequently in the future (presumably as a means of balancing nature).

Winner’s curse:

Winner’s curse is the tendency for the winning bid to exceed the worth of an item.The person who wins the bid overestimates its worth the most, as they were willing to go above and beyond what a presumably rational person is willing to bid. So, the fact that they won means they paid more than the item is actually worth in the market, as they pay more than other people have valued the item at.

Tendency to make sure that a competitive bid is won even after overpaying for the asset. While behaviourally it is a win, financially, it may be a loss. In these emotional and overwhelming situations, it can be difficult to make rational decisions about an item’s value, and people often fall victim to the winner’s curse

Herd mentality:

In behavioral finance, herd mentality bias refers to investors’ tendency to follow and copy what other investors are doing. They are largely influenced by emotion and instinct, rather than by their own independent analysis. This guide provides examples of how investors may succumb to herd bias

This is a common behavioral disorder in investing community. This bias is an outcome of uncertainty and a belief that others may have better information, which leads investors to follow the investment choices that others make. Such choices may seem right and even be justified by short-term performance, but often lead to bubbles and crashes. Small investors keep watching other participants for confirmation and then end up entering when the markets are over heated and poised for correction. Most of the individuals don’t go against the crowd as economist John Maynard Keynes said:

“It is better for reputations to fail conventionally than to succeed unconventionally.”

Example

Crypto currencies have been in the trend for quite some time now. Names such as bitcoin and Etherium have become popular. Many industrialists and popular business figures are jumping on the bandwagon, Elon Musk being one of them. People know him as a smart investor and a successful businessman, and naturally, the community will believe that he knows something that they do not. Therefore, they tend to follow his actions blindly.

Musk endorsed a popular meme coin which made the coin’s price soar to rocket highs. The prevailing trend is that people invest in it whenever he puts up a tweet, and when the effect wears off, the prices go down. Despite the creation of coin being a joke, people invest in it because a famous and successful person invested in it; for whatever reasons. This can and has led to many investors suffering losses who had put in huge money to make a handsome profit.

Anchoring

Anchoring is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered when making decisions. Investors hold on to some information that may no longer be relevant, and make their decisions based on that. New information is labeled as incorrect or irrelevant and ignored in the decision making process.

Investors, who wait for the ‘right price’ to sell even when new information indicates that the expected price is no longer appropriate, are exhibiting this bias.

For example, they may be holding on to losing stocks in expectation of the price regaining levels that are no longer viable given current information, and this impacts the overall portfolio returns. Actually, the decision should be made purely on the basis of what price and value difference exist today in light of available information rather than based on what the prices were in the past.

Investor Behavior

If you have questions , consider reaching out us