Princeton University psychologist Daniel Kahneman, who recently passed away at the age of 90, was a pioneer in behavioral economics and won a Nobel Prize for his work establishing the relationship between psychology and economics.
prospect theoryThis work, for which Kahneman was awarded the Nobel Prize, proposed changes in the way humans make decisions in the face of risk, especially those associated with investments.
Amos Tversky and Daniel Kahneman conducted a series of psychological experiments and found that investors value profits and losses differently, placing more emphasis on the recognition of gains and the recognition of losses.
Investors feel the impact of a loss is greater than a gain, even if the amounts are exactly the same.
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Example: Given a choice between receiving 500 rupees or 50% chance of winning 1,000 rupees, the probability of choosing the first option even though both options have exactly the same expected value will be higher.
Why is this important?
An overwhelming fear of loss can cause investors to act irrationally and make poor decisions. Once you become aware of your biases, you will be better equipped to make rational decisions.
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Let’s look at some real-life examples of bias in investing and apply the timeless lessons taught by Daniel Kahneman.
Example 1: Timing the market
Markets are like complex mechanisms that are influenced by various macro- and micro-economic parameters. Trying to predict where things will go next is a futile exercise, but investors often try to predict the market in hopes of increasing profits.
of group psychology bias Refers to the tendency of investors to follow and imitate what other investors are doing. They are heavily influenced by emotions and instincts rather than independent analysis.
According to Nifty’s 23-year study, if you miss 43 days out of a total of 5950 days, your investment returns will be 1.15x, whereas if you invest and do nothing, you will get a 12.7x return.
Since the frequency itself is low at 0.72% over 23 years, the chances of earning a positive return on these outliers are very low.
Example 2: Invest only in brands you use
Just because a brand is popular or you use it in your daily life doesn’t mean your investment will be profitable.
of known bias This is a phenomenon in which people tend to prefer familiar options over unfamiliar options, even when the unfamiliar options are objectively better.
When people encounter familiar options, they are likely to experience cognitive ease, which may make those options seem more appealing.
To avoid known bias, it is important to carefully evaluate all options, including unfamiliar ones, and consider their relative indicators rather than relying solely on what is known.
Example 3: Selecting mutual funds based on one-year returns
Investors often look at recent performance and are influenced by these numbers when selecting funds and investment strategies. However, this may not be the right approach as there are several other parameters that need to be evaluated when choosing an investment product.
of recency bias It is a cognitive bias in which people prefer recent events over historical events. This gives the illusion that similar events are likely to occur in the near future.
To combat this bias, especially when choosing mutual funds, several parameters should be considered, such as rolling Sharpe ratio, downside capture ratio, maximum drawdown, and consistency of performance over time. Recent returns and point estimates can be misleading.
Example 4: Owning loss-making stocks
Investors often hold on to investments that have lost money in the hope that the losses will be recovered in the future. This is because recording a loss is emotionally much more taxing than recording a profit.
of loss aversion Bias refers to the phenomenon in which individuals perceive potential losses to be psychologically more severe than equivalent gains.
This can be avoided by taking a systematic approach to investing. When making an investment, write down anything that could go against your decision and set appropriate stop losses.
To reduce the impact of losses, find better alternatives to the losing stocks and transfer the money to better opportunities. That way, you feel less of a loss because you’re simply moving one investment to another.
Example 5: Falling into the trap of making a quick buck
“Earn 5% monthly recurring revenue.”
“Invest in cryptocurrencies and double your money.”
Statements like this paint a positive picture in the minds of investors because they frame their minds based on what they want to hear.
of framing effect Bias is the way our decisions are influenced by the way information is presented. Equivalent information can be more or less attractive depending on the features highlighted.
For example: Consumers are more likely to prefer the label “90% fat-free” to the label “only 10% fat” when both are essentially the same.
If an investment sounds too good to be true, it’s probably very risky. Don’t be fooled by attractive statements, consider the historical risks, potential losses and costs of such investments to understand the full picture.
Daniel Kahneman explains many of these biases in his book Thinking Fast & Slow, one of the most influential books of all time. He is certainly one of the most prominent figures of this century, and his teachings will remain with us forever.
Rohan Borawake is co-founder and CEO of FinSharpe Investment Advisors, and Sabir Jana is co-founder and head of quantitative research. Views are personal and do not represent the position of this publication.
Rohan Borawake Co-founder and CEO of FinSharpe Investment Advisors. Views are personal and do not represent the position of this publication.
Sabir Jana Co-founder and Head of Quantitative Research at FinSharpe Investment Advisors. Views are personal and do not represent the position of this publication.
