3.1.11 Behavioural Biases

A few biases worth knowing by name

Loss aversion is the tendency to feel the pain of a loss more sharply than the pleasure of an equivalent gain, which pushes many investors to sell at exactly the wrong moment during a downturn. Recency bias is the tendency to overweight recent events and assume they will continue, which drives chasing whatever has performed best lately. Herd mentality is following the crowd into or out of an investment simply because everyone else appears to be doing so.

Behavioural biases are systematic patterns of deviation from rational decision-making that affect virtually all investors. They are not character flaws; they are features of human cognition that served survival purposes in other contexts but produce poor outcomes in financial markets. Recognising them is the first step toward building defences against them.

Loss aversion, documented by Kahneman and Tversky, is the tendency to feel losses roughly twice as intensely as gains of the same magnitude. This bias causes investors to sell winners too early (to lock in the pleasure of a gain) and hold losers too long (to avoid the pain of realising a loss). In an investment portfolio, this produces the worst possible outcome: cutting the compounding potential of successful holdings while allowing unsuccessful ones to consume capital.

Why these biases are expensive

Studies comparing the return an average fund earned against the return its average investor actually earned consistently find a meaningful gap, and that gap is largely attributable to poorly timed buying and selling driven by exactly these biases, rather than to picking bad funds in the first place. The fund itself often performed reasonably well; the investor's own timing decisions are frequently what fell short.

Recency bias causes investors to overweight recent experience. After a three-year bull market, investors become overconfident and increase equity allocation at exactly the wrong time. After a sharp correction, they become excessively cautious and miss the recovery. The Indian SIP flow data shows this pattern clearly: SIP registrations surge after markets have already risen and slow after corrections, which is the opposite of what rational investing would suggest.

Confirmation bias causes investors to seek information that supports their existing position and dismiss information that challenges it. An investor who has committed to a particular stock or fund manager will unconsciously filter news and analysis to confirm the wisdom of their choice, ignoring warning signs that objective analysis would flag. This is why portfolio review is best done with a structured checklist rather than an open-ended assessment, which is vulnerable to confirmatory framing.

Practical defences against your own biases

Automating investments through SIPs removes many timing decisions from active, in the moment judgment. Writing down an investment plan and its underlying reasoning in advance, before any crisis hits, gives something concrete to refer back to when emotions are running high. Limiting how often you check portfolio value can also reduce the number of opportunities for these biases to actually influence a decision.