Behavioural Biases in Investing: Types & How to Avoid Them

Imagine you have been watching a stock rise for weeks. Everyone around you seems to be talking about it, social media is full of success stories, and suddenly you feel like you are missing out.

You finally invest. A few days later, the price starts falling.

Now another thought kicks in: “I’ll just wait. It will come back.”

This is how behavioural biases in investing often work. Our decisions are not always driven by numbers or research—fear, FOMO, confidence, past experiences, and what others are doing can influence us more than we realise.

And this can happen to anyone, whether you are new to investing or have been in the market for years.

Before we dive into the most common ones, let's understand what they are, why they happen and how they can subtly influence investment decisions.

What Are Behavioural Biases in Investing?

Investor behavioural biases are the feelings, habits, and thought processes that affect an investor's decision on what to invest in.

In simple terms, sometimes investors don't make decisions using only the facts, research, or logic. Emotional factors, such as fear, FOMO, overconfidence, loss aversion, and herd mentality, can affect our purchase, sale, and retention of an investment.

For instance, when an investor has an asset that is declining, he or she may not want to sell because he or she is afraid of losing money. Another may purchase a trending stock because it appears everyone else is making money from it.

Cognitive vs Emotional Biases in Investing

Not all behavioural biases in investing are the same. Some come from how we think, while others come from how we feel.

Cognitive biases are a result of faulty thinking patterns or the way information is being processed. An investor may, for instance, attach too much importance to the recent market trend or search for information only to confirm an opinion that the investor already has.

Emotional biases are more a function of emotions such as fear, greed, regret, or excitement. Emotional factors can be very influential in investment choices, especially when investing during times of market volatility.

Cognitive biases have to do with how we think, and emotional biases have to do with how we feel and react. Both can impact what investment choices we make.

Most Common Behavioural Biases in Investing

If you don't consider yourself a professional investor, you might already be feeling them in your everyday financial choices—from shopping to saving to dealing with prices. The following are the most common ones explained practically:

1. Loss Aversion

Loss aversion is the aversion to losses experienced, compared to the satisfaction felt from gains.

For instance, if you purchase a pair of shoes for ₹2000 but later discover they are not comfortable, you would like to return them for a better pair. You might continue to wear them if you don't like them, simply because you don't want to “waste” the money.

It's the same with investing. When someone purchases a stock that begins falling, they might not want to sell it because it is painful for them. Thus, they continue to keep it and hope the price will recover—even though they may find a better opportunity out there.

2. Overconfidence Bias

Overconfidence bias is the tendency to have self-confidence in our abilities above what they actually are.

For example, if someone can guess a couple of cricket match results and starts to think that he or she can guess all of the results, they may become overconfident in their ability to make accurate predictions.

When it comes to investing, a handful of good stock picks can make the hands of an investor feel like they “understand the market.” This can result in a lot of trading or making large gambles without doing adequate research.

3. Herd Mentality

Herd mentality is when people do what others are doing without considering it.

For instance, if you and all of your friends suddenly decide to purchase a new smartphone, you may feel compelled to purchase the same smartphone since you think you need it.

In investing, it occurs when individuals purchase a stock based on the belief that everyone else is buying it or if it's trending on social media. In times of market upswings, this trend is even more pronounced because of FOMO – fear of missing out.

4. Confirmation Bias

Confirmation bias is the tendency to search for information that confirms our beliefs.

For example, you think a restaurant is awesome, you may only see positive reviews and overlook the negative reviews that others have had.

In investing, when a person likes a company, they may only take in the positive information about the company and disregard the negative information such as declining profits or rising debts. This can result in faulty and hazardous choices.

5. Anchoring Bias

Anchoring bias occurs when one becomes stuck on a certain number or initial impression.

For instance, you might think that if a shirt was originally priced at ₹2000 and is now being sold for ₹1200, it is a “great deal” even though the shirt isn't actually worth that much.

In investments, the concept of "wait for it to come back up" is used when the price of a stock falls from ₹1,000 to ₹700. The original price remains the “anchor” price, regardless of a company's change in circumstances.

6. Recency Bias

Recency bias is when we give too much importance to recent events.

If it has been raining for a couple of days, for instance, you may think that it will continue to rain for the rest of the month, but weather can change at any time.

When the market has been going up recently, investors might think that it will continue. If it has been dropping, they might assume that it will continue to drop. Markets don't always head in one direction.

In real life, these biases may be small, but in financial matters, they can have a big impact, particularly when investing. They can have an impact on returns, risk-taking, and financial growth over time.

The problem is, it is sometimes easy to believe that the decisions you make are “the right ones” at the time. Based on these trends and patterns, investors could make rational investments.

How Behavioural Biases Affect Investment Decisions and Portfolio Returns

Behavioural biases may affect the way in which investors buy and sell, handle risk, as well as react to market fluctuations. They can have an impact on portfolio diversification and long-term portfolio returns over time. Common examples include:

• Buying because of FOMO rather than research
• Selling in market panic
• Holding losing investments for too long
• Taking unnecessary risks
• Trading too frequently
• Ignoring information that challenges an existing view

The problem is, sometimes these decisions seem like the logical thing to do on the spot. Being able to identify these trends can help investors make informed and disciplined decisions.

How to Identify Behavioural Biases in Your Own Investing

Behavioural biases are often all too easy to fall into and can appear as a normal way of making a decision. When you're thinking of investing, do the following:

• Am I investing because I researched it or because everyone else is?
• Am I taking more risk because of recent success?
• Do I still want to purchase this investment at the current price?

Use these questions to determine if emotional or biased decision-making has occurred and before it becomes a costly error. It's also very helpful to keep a simple investment journal so you know whether you're making an investment based on research or emotion.

Practical Ways to Overcome Behavioural Biases in Investing

 Reducing the impact by a disciplined approach:

1. Follow an Investment Plan

Before investing, establish goals, risk limits, and a time horizon. This can help to minimize impulsive decisions during market downturns and market rallies.

2. Don't Follow the Crowd Blindly

Trending doesn't necessarily mean right, as in investing. Don't make any rash decisions out of FOMO or herd mentality; investigate it first.

3. Set Rules and Take a Pause

Set up a time plan for buying, holding, and/or selling. Before making a major decision, ask: “Am I reacting to facts or to fear and excitement?”

4. Diversify Your Investments

Don't invest too much in any stock, sector, or asset. Diversification can lessen the effect of a negative investment.

Finally, it's not about taking the emotions out of investing, but about not letting the emotions rule all of your investing decisions.

Conclusion

Investing behaviour can influence the type of investment, when to invest, and the amount of risk. Loss aversion, overconfidence, herd mentality, and recency bias are some of the other biases that can work in the background.

Emotions cannot be eliminated, but they can be prevented from being in control.

So, the next time you are feeling FOMO, you should ask yourself:

Am I reading the facts or my bias? One pause could be the difference between a smarter investment choice.

Read More - Key Clarification on PPF Rules: Understanding the Impact on Minor Accounts

FAQs

Q1. What are some financial behavioral biases?

Ans: Loss aversion, overconfidence, herd mentality, confirmation bias, anchoring, recency bias, and disposition effect are common behavioral biases in finance.

Q2. What are some ways to mitigate behavioral biases for investors?

Ans: By raising awareness, investing in a disciplined manner, seeking expert advice, and thinking long-term instead of short-term.

Q3. What is the significance of behavioral finance in investing?

Ans: Behavioral finance helps investors understand how emotions and biases can influence their investment decisions.

Q4. Can behavioral biases be avoided?

Ans: They cannot be eliminated but can be minimized with education, self-awareness, and working through a decision-making framework.

Q5. Where do I go to find out if I am being influenced by a behavioural bias when making my investment decision?

Ans: When investing, look at your decision, feelings, research, and influences, and uncover potential behavioural biases.