Mistakes that investors make :Director, Quantum Asset Management Company: Business Line

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“A man, who has committed a mistake and doesn't correct it, is committing another mistake.” — Confucius

At review here is the general behaviour of investors and some of the common mistakes they make.

Everything, including markets, move in cycles partly because people or investors either commit the same or similar mistakes or simply do not learn from their past ones. Additionally, new investors come with their set of biases and commit fresh mistakes.

The behaviour also sets into motion a sort of a feedback system, and makes the investor commit the same mistake. It might appear that a mistake with a known consequence would be less painful than other behaviour.

Since the behaviour is similar, the markets reflect this behaviour and thus, similar mistakes are repeated time and again. For example, investors rely on street advice (such as tips from friends), get carried away, invest at the top of the market, get frustrated with the performance and desperately sell out at the bottom.

Here are a few examples of where mistakes come from:

Bias from mere association: It includes liking or disliking something associated with something bad or good. This causes investors to stop viewing opportunities in an unbiased way resulting in poor decisions. For instance, if a particular investment, say in a cement company, bought at the top of the market failed, it would be incorrect to impulsively conclude that investing in all cement companies is not worthwhile. Avoiding cement companies totally may result in missed opportunities.

Over optimism: This encourages investors to take risks that they are not fully equipped to handle. Over optimism can cause unreal expectations resulting in expensive disappointments.

Bias from consistency tendency: This arises by being too consistent with our prior decisions. The more time, money and effort is spent, the more the investor will feel the need to continue and value the decision highly, without considering whether or not it is right.

Status quo bias: This includes preference to leave things as they are or preference for default options. This could lead to poor asset allocation. As the investor's age, risk appetite or financial condition changes, there is a need to relook the asset allocation. However, investors tend to continue with their past asset allocation, and even procrastinate taking any decision to change it.

Bias from anchoring: This comes from over weighing certain initial information as a reference point for future decisions. For example, investors who missed the boom in stock markets since 2003 when the average index (BSE Sensex) level was 387, might be anchored to that number and refuse to invest till that number is reached. They are anchored to that index level and overlook the big growth possibility in future.

Lack of understanding incentive systems: Never ask the barber if you need a haircut. We are biased by our incentives and so are others. What is good for others may not be good for us. Advisors are needed but be cautious of the advice given, particularly free advice or tips.

The above biases result in poor choice of investments and a sub-optimal portfolio construction, which is too concentrated or much diffused.

It may also result in frequent shifting between asset classes and within asset classes. This results in high expenses, possibly high taxes and does not allow your money to compound.

REDUCE MISTAKES

To reduce mistakes we should study failures. For instance ask yourself what mistake to avoid. If it is, say, herd mentality, what is the cause? It is unwillingness to think hard. The easy way out is to follow others. But what is the remedy? Ask yourself, what if the herd is wrong. What will be the consequences and can I live through those?

In conclusion, successful investing, just like a successful career, is not about maximising brilliant moves, rather it is about minimising mistakes.

(The author is Director, Quantum Asset Management Company. The above theories on investment behaviour have been adopted from various research papers. )