Real Life Emotional & Cognitive Biases simplified for a Retail Investor
“We can be blind to the obvious, and we are also blind to our blindness.” – Daniel Kahneman
Emotional and Cognitive Biases: Let us begin with a story of a small retail stock trader and insurance broker, Mr. Shanti, aged 48 years. One day when the Indian stock markets opened at 9:15a.m, he was perplexed to see that one of his small cap infrastructure stock which a day before was at INR 120, had dropped by 18% within half an hour of trading. He had invested INR 29,160 in this stock in June 2019; when he saw an article about the stock in the daily newspaper and also saw a few analysts talking about the stock in the business news channels on the same day. He then did his basic research on the stock and when satisfied, placed an order for buying the stock at a price of INR 108. Now, on the day when the stock fell more than 18% during the day and closed down 15%; there was a news that 27% of the company’s shares were pledged by the promoter. He however was quite confident that this is not a major problem and fundamentals are intact. The next day the stock again fell by 10% and over the week the stock halved in value. Mr. Shanti thought that this phase would pass and that as soon as the stock recovered or bounced back to his original cost of INR 108, he would exit the company. This story ends with the same climax that many retail
investors faced while investing in small or mid cap companies (cap stands for market capitalization; meaning total market value of the company). As you would have guessed, the climax was that the stock in 6 months’ time went to INR 10 (as during those six months it came out that the promoters were fraudulent). Our Mr. Shanti still has 270 stocks lying in his DP worth only INR 2,700. This is quite a common story for a small investor. Did Mr. Shanti act rationally or was driven by some biases? We shall answer these questions in a while, in fact you shall be able to answer them after reading this article. First let’s learn about some emotional and cognitive biases that affect our decision making consciously or subconsciously. Here, let me pause and share with you that I am not an expert in this field and am just a novice learner of behavioural finance; I also would want to confess that even I have fallen prey (and still am subject) to several of these emotional and cognitive biases.
List of ten emotional & cognitive biases:
Loss Aversion and Disposition Effect – In this bias we have a stronger tendency to avoid losses relative to realizing gains. We react more negatively to a given amount of loss than positively to the same amount of profit. Disposition effect leads to holding of investments that are at losses for a much longer period of time and selling profit making investments too quickly. This is exactly what a rational investor should avoid doing. Self-Control bias – This is one of the emotional and cognitive biases when we are tempted to give up our self-control or self-discipline for some short-term pleasure. For example – a retail investor who is not well informed, is letting go of self-discipline while speculating in penny stocks or small caps. This we do to satisfy our desire to become rich from stock markets overnight; which leads to letting go of risk aversion (which is the tendency to choose capital preservation over higher returns) Overconfidence bias – By nature, majority of human beings are confident of their own abilities. I believe we should be confident. But the problem begins when we become overconfident; specially in stock selection or understanding the market. Overconfidence bias leads us to overestimate our knowledge of the stock and our ability to understand its business fundamentals and consequently evaluate the impact of good or adverse news on the stock price. Self-attribution bias – For example, you suggested an IT stock to Mr. Sheetal and an NBFC stock to Mr. Vimal; IT stock appreciated significantly and the NBFC stock corrected (fell) significantly. When you meet Sheetal; you say “see my analysis; what a superb return the stock gave” but when you meet Mr. Vimal you say “the market corrected that’s why the stock fell”. This is self-attribution bias. Availability Bias – We tend to focus on information that is easily available to us. If we get a stock idea easily; we start believing on the viability of that idea. For example – acting immediately on an investment advice that you read early morning in the newspaper is availability bias. Status quo bias – It is the tendency to avoid taking any action. Once an action is taken, we prefer remaining status quo than changing our actions. Because of status quo bias we tend to hold on to our stocks even though they are proved to be incorrect decisions. Endowment bias – It is an inclination to value an asset more when you own it or possess it relative to when you do not own or possess it. We have the tendency to quote higher prices when we want to sell
something than if we were to buy the same thing. This leads to an illusion that what we own is valued more, irrespective of its fair market price; hence we tend to hold them for a longer period of time than required.
Regret Aversion Bias – It is a tendency to not take any decision because of the fear that what if, the decision we take turns out to be bad. Holding onto a stock for a much longer period of time than required; in order to avoid the regret caused from the chances of price rallying (increasing) after we sell is due to regret aversion. Anchoring Bias – We have a tendency to get anchored to certain numbers or aspects while taking decisions. For example, keeping a target in mind for selling a stock or buying a stock and not acting till it reaches that price is some sort of anchoring. Belief Perseverance Bias – It occurs when we ignore new information that contradicts our earlier held belief based on which we have already acted upon. Here we do not modify our belief. For example, if we have bought a stock then we stress upon only the positive information and ignore or underestimate the effects of all the negative information. By now, I guess, you would have identified which emotional and cognitive biases Mr. Shanti was acting upon in our story. Please feel free to comment the name of the biases (amongst these 10) that you believe Mr. Shanti had. Remembering the name of the biases is secondary; but acknowledging that we human beings show these biases and several other emotional and cognitive biases during decision making; is the key here. Some of these we can overcome; while some of the biases are so inherent that they cannot be overcome. The ways to overcome, may be, might cover in some other article; provided this finds your interest. The first and the most important step to overcome the biases is to acknowledge that we are biased beings.
One quote I came across while attending my certification from Duke University is quite impressive; “The human understanding, when it has once adopted an opinion, draws all things else to support and agree with it” – by English philosopher Francis Bacon. Let’s end this with a quiz – In each of the below case you are showing a bias (there can be more than one biases playing at a time). A challenge for you! If you can identify the emotional and cognitive biases, then feel free to drop a line in the comments section mentioning which ones can you identify (also a rationale would be welcome): Case 1. You bought a Banking stock, as soon as an analyst recommended it on a business news channel? Case 2. You want to sell one of your Utility stocks bought at INR 630 at not below its acquisition cost; it is currently trading at 450. You like the stock and feel its value should be more than your cost. Case 3. You sold a Pharma stock that was doing pretty good; it came out with market beating results as well? You bought it for long term but sold within 6 months. Trivia: 1. Loss aversion bias was identified by Daniel Kahneman and Amos Tversky (1979) 2.
In 1985, Shefrin & Statman coined the Disposition effect
3.
Status quo bias was coined by Samuelson and Zeckhauser (1988)
Sources & References: The CFA Institute, USA Refresher Reading for members “The Behavioural Biases of Individuals” and Duke University AUTHOR: CA Jinesh Sarat Sheth ACA, CFA CA Jinesh Sarat Sheth, ACA, CFA holds the designation of Investment Director; presently Heading Investment & Research Team of a Highly Reputed Family Office based in Kuwait. He is also a Member of the US “CFA Institute Practice Analysis Working Body” for the year 2020. He is an enthusiastic writer having written articles for The Institute of Chartered Accountants of India (ICAI) Local & International Chapters, The Institute of Cost Accountants of India (ICMAI) Journal & Industry magazines.
