PMS Bazaar published a special edition (magazine) with interviews and articles from various industry experts who shared their insights on the Indian alternative industry. Here is a write-up on the behavioural biases that impact investment decisions.

Topic: Behavioural biases on investments and Magadh Capital portfolio strategy

Author: Vipul Prasad, Founder & CEO, Magadh Capital Advisors LLP

The ability to curb investing mistakes is crucial for wealth creation via equities. Equally important is the mental discipline to benefit from the occasional opportunities that the market offers. It is not for nothing that Warren Buffet speaks so highly of temperament for succeeding in stock markets.

The human brain works with several thumb rules to simplify and accelerate decision-making. These thumb rules are drawn from our personal experience and preferences. Some of these thumb rules, known as behavioural or cognitive biases, lead us to poor decisions.

Investing requires intense focus on such cognitive biases to avoid mistakes. At Magadh Capital, we have in place a formal behavioural finance framework to support our fundamental analysis processes. We are cognizant of the fact that unless controlled systemically, our decisions and forecasts can be adversely affected by our behavioural biases.

Magadh’s investing process also places a lot of emphasis on introspection by analysing its judgement post-facto - trying to see motivation and the science behind its choices.

Magadh Capital encounters these five behavioural biases regularly

Loss aversion

We humans are wired to dislike losses much more than we like gains. Thus, we pass up even favourable bets if there is any chance of a loss. It is this bias that prevents us from accepting even temporary capital erosion in stocks with great medium-term appreciation prospects. To an extent, this is the inherent reason why many people invest in bank fixed deposits instead of equities. Loss aversion also acts as a key basis for the sunk cost bias. Investors, who attempt to time the market, are often driven by loss aversion bias. The antidote that Magadh Capital applies against this bias is a conscious approach based on probabilistic thinking. Magadh’s decision-making process works with a payoff matrix where we assign probabilities to various outcomes.

Sunk cost fallacy

Reluctance to sell a stock at a minor loss even if there is realization that it will perform poorly is caused by a commonly encountered cognitive flaw- the sunk cost fallacy. Here a layman remains fixated with the portfolio stock’s purchase price instead of its prospects.

This affects equity investors in another related way too – via the disposition effect. When he/she needs cash, an investor has to decide which stock holding should he/she reduce. An untrained human mind often forces a decision based on stocks’            trailing performance. As a result, stocks that have performed well so far are the ones that get trimmed. This helps in closing our mental account in positive territory.

However, this process is flawed. The stock to be sold should be decided based on relative prospects - then - for all portfolio stocks.

To avoid the sunk cost fallacy an active, engaged and disciplined mind is required. One needs to consider the counterfactual possibilities. Would the above investor have held on to a bad stock hoping to sell at a profit, if he/ she had inherited it from his/ her father?

Overconfidence

A   high level of confidence in an opinion cannot be, in itself, a sign of the correctness of this opinion. Behavioural finance experiments, on the contrary, prove that the more confident a forecaster is in his forecast, the worse his forecast turns out to be. Further, overconfidence nudges investors towards recklessness and away from rigour in analysis and hence generally leads to poor outcomes.

Overconfidence can manifest itself in many forms – overconfidence in one’s ability to forecast future earnings of a company, to judge the management’s capabilities, or to buy a stock at a bottom and sell at a peak. Magadh Capital believes in having strong opinions held loosely. Accepting that luck plays an important part in investing, and in life, helps us stay humble with our opinions and work hard to arrive at conclusions.

Bias blind spot

Ironically even while blindly following the herd most of us tend to think that we are different from the consensus, and that consensus is wrong.

So how does someone late to a stock market rally (which may be peaking) justify one’s fresh buying? Simply, by concluding that consensus is too pessimistic and is unable to see the blue-sky scenario that one “knows will happen”.

This behaviour, known as bias blind spot, is a bias that prevents people from spotting the impact of biases on their own judgment even though they mistakenly feel that they recognize the impact of bias on others’ judgment. Humility again, intellectual resilience and flexible thought processes are the traits that we at Magadh Capital apply to overcome this bias.

Terminal paralysis

Terminal paralysis prevents us from acting even on favourably loaded games if the environment is adverse. For example, most of us are perennially waiting for the equity markets to tank by 25-30% so that we can load up on stocks paving the way to a wealthy future. Unfortunately, terminal paralysis bias often takes control in the event of a sharp slump in markets. In the real event of a 25-30% market crash, the accompanying pessimistic environment makes it difficult to make new purchases.

To defy terminal bias, we effectively tie ourselves to a decision – buy, sell, or hold.

Conclusion

Thus, at Magadh Capital, generally, we are ready with names of stocks that can offer good entry opportunities at certain price points. When those price points are achieved, we make the purchase– irrespective of the market environment.

To sum it up, to be able to act in a rational fashion we need to be aware of these behavioural biases first. Magadh Capital analyses the possibility of these biases in every investment decision with a checklist. Then, conscious thinking and willpower help us overcome most of them. Advanced research and pre-commitment to follow one’s analysis are the keys here.

To read more interviews and articles on multiple topics related to the Indian alternative industry from our special edition, click HERE.