Emotional Biases: The Unconscious Mind and Using It to Our Advantage for Trading

At RKSV, many of our traders focus on the F&O segment, where the fluctuations in the prices are high. A lot of times traders indulge into trading which is more emotional decisions rather than optimal (which is not the best thing to do).  I hope to throw some light on different Emotional Biases we undergo and how they rule our mind. We cannot change our emotions but we can definitely recognize it and adapt to it to make better decisions. So, let's start...

Emotional Biases

Although emotion has no universally accepted definition, it may be thought of as a mental state that arises spontaneously rather than through conscious effort. Emotions can be undesired to the individual feeling them. Although they may wish to control the emotion and their response to it, they often cannot.  As emotions are not conscious calculations, its harder to correct them and it can cause an investor to make sub-optimal decisions. It has more to do with how people feel, rather than how people think.  There are different types of emotional biases.  Here we will visit a few of them.

Loss Aversion Bias

• It is the bias in which people tend to strongly prefer avoiding a loss as opposed to achieving a gain. Psychologically, losses are significantly more powerful than gains. The utility derived from a gain is much lower than utility given up with an equivalent loss. Ideally, individuals should accept more risk to increase gain, not to mitigate loss; however, it always happens otherwise.
• People tend to hold on to losses even if the investment has little or no chance of becoming profitable. In case of a gain, people lock in profits, thus limiting their upside potential. This also results in excessive trading because of selling winners. Excessive trading has been shown to lower investment returns.
• A disciplined approach and realistically considering probabilities of future losses and gains to an investment is a good way to alleviate the impact of loss aversion.

Overconfidence Bias

• It is a bias in which people demonstrate unwarranted faith in their own intuition, judgment or abilities (gut feeling and hope). This is because people experience an illusion of being knowledgeable (people believe they are smarter and better informed then they actually are) and self-attribution bias (bias in which people take credit for success and blame other factors for failure).
• It is difficult to correct for because it is hard for people to revise self-perceptions of their knowledge and abilities. As a result, individuals underestimate risk and overestimate expected returns. They hold a poorly diversified portfolio,  trade excessively and experience lower returns.
• To overcome the same, an investor should do a post investment analysis on both successful and unsuccessful investments and review their investment decisions.

Self-Control Bias

• This is a bias in which people fail to act in pursuit of long-term goals because of a lack of self-discipline.  There is always a conflict between the short-term satisfaction and achievement of some long-term goal.
• Money is one of the areas, along with weight loss, smoking, etc. where people have demonstrated lack of self-control for short-term enjoyment over long-term benefits. Individuals have a bias towards small payoffs now compared to larger payoffs latter.
• To overcome the same, individuals should make sure they have a proper investment plan in place. As it is said, "Failing to plan, is planning to fail".

Status Quo Bias

• It is an emotional bias in which people prefer to do nothing, instead of making a change. People are more comfortable keeping their positions the same instead of looking for other beneficial changes.
• Unknowingly people maintain portfolios which are riskier and fail to explore other opportunities.
• To overcome this bias, education is essential. Individuals should quantify the risk-reducing and return enhancing advantages of diversification and proper asset allocation.

Regret-Aversion Bias

• Under this bias people tend to avoid making decisions out of fear that the decision will turn out poorly. People try to avoid the pain of regret associated with bad decisions. People are reluctant to sell because they fear that a position will increase in value and then they will regret having sold it.
• Regret aversion can persuade us to stay out of the stock market just when the time is right for investing. On the upside, fear of getting in at the high point can restrict new investments from taking place. As a result, people either become too conservative  or engage in herding behavior (investing in popular stocks, as it seems safe to be with the crowd)
• To avoid this, people should be educated about diversification and they should understand losses happen to everyone and should keep in mind the long-term benefit of investing in riskier assets.

Conclusion:

Emotional biases stem from impulse, intuition and feelings and may result in decisions that are not reasoned. Educating about the investment decision-making process and portfolio theory can be helpful.

First time always comes only once... so is my start to blogging. Very excited about my first ever blog and am hoping it helps everyone. The biggest decision to make was to decide "the topic" to launch. Being a CFA candidate, I always had the bias towards the Stock Fundamental and Valuations and always wanted to give my little to the investing world so that they also learn to look at the stock market as value investing rather than as a casino (knowing our markets -- this will take some time). But before actually starting to launch all the Fundamental Analysis and Valuation topics, I decided to start with a light and interesting topic of Emotional Biases. Hope you all enjoyed reading the same.