Memo to investors: Outsmart your own biases

Sanjiv reached out to me as he was unsure about the course of action on his portfolio. Sanjiv had been investing in a combination of fixed deposits and mutual funds and had diversified into alternate products like stock baskets and US technology stocks over the last 2 years. Sanjiv wasn’t sure if he should continue with these investments given that Nasdaq is down by 30% YTD with individual stocks like Tesla down by 35% YTD.

Like other investors, Sanjiv had exited some of his mutual funds believing he could generate better returns in stock baskets and US stocks, only to see a big downturn in these investments. In such situations, investors tend to panic-sell and stay in cash, thereby compounding the damage.

These actions and how a lot of investors behave in different market situations are due to their biases. Enough has been written about biases which play out on a regular basis like herd mentality, FOMO (fear of missing out) and loss aversion. However, investors also need to be mindful of three other biases which can impact their portfolios significantly. They are:

Recency Bias

Recency Bias is very common and investors tend to rely on recent information for financial decisions over long-term objective data. Why else investment products would get the most inflows when the associated markets were at a high? Sanjiv, too, was influenced to invest in US stocks based on their near-term performance being better than Indian stocks or was considering stock baskets over mutual funds, just because they showed better point-to-point returns.

Overconfidence precedes carelessness

When markets are at a high, investors tend to think they know better and can achieve higher returns than professional fund managers. Overconfident investors denounce professionals and believe they can make all the right moves. What plays out is that investors end up with deeper losses and feel unsure about the next step.

Not admitting mistakes

Investors hate admitting mistakes and tend to justify them to preserve their image. The easiest is to blame financial advisors. I have come across many cases wherein clients force their advisors to exit simple investments like mutual funds in favour of trending investments. Investors rationalise what they did and pretend that it was the right thing to do. The biggest downfall for investors is when they let their egos take over.

This uncertainty can be killing for most investors.

Here is what investors should do:

Do not compare short-term overperformance in a trending investment with investments that have long-term track records. Every fund goes through upcycles and downcycles and these are temporary. Investments in low-cost, diversified portfolios do rebound and beat exotic investments in the long run.

Being focussed on goals and staying the course based on risk tolerance always helps. Setting portfolio parameters like asset allocation that do not change with changing markets is important. Finally, humility is the ultimate form of risk and portfolio management.