Modules for Investors
Investment Biases - Part 1
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The Optimism Bias and Its Impact
If the human race had not been optimistic, it would not have evolved to the point it has reached now. In life, with all the uncertainties, fears, and doubts, it is only possible to survive and overcome by having confidence and being optimistic. But sometimes, it makes you so confident that you reach the point of irrationality and lands into the hole of wrong decisions. This is called optimism bias.
Optimism bias often leads us to have an impractical approach towards things, much like looking at life with rose-colored glasses. It makes the investor irrational towards the processes, thinking their knowledge and experience surpasses everything else and establishes superiority. But often, this optimism and overconfidence bias leads to huge investment mistakes that are hard to deal with.
When the market is performing well, and the investments are giving profitable returns, investors tend to be overly optimistic with their abilities and intelligence and become sure of the future profits altogether. This can go far as them believing that no investment can turn out to be a bad investment to them now.
Once Mr. Manish Jain predicted a profit return of 24% in the year 2020, after having a reasonably prosperous 2019 with investment returns of 18%. The return rates have been gradually increasing for him in the past eight years of his investment model, with a fair 3-4% boost each year. But to take a leap of faith and invest double with the hope of double returns, one might call this being an overconfident approach. Up until March, Mr. Jain was, sure enough, celebrating the good year on an International vacation trip with the family, but as the world turned upside down post-March, and the year went ahead under lockdown, so did Mr. Jain’s expectations.
As implied, these can lead to consequences that are harmful to the investor-
- Underestimating risk factors
- Excessive trading
- Overestimating returns
- Ignoring any contradicting news
- Experience below-market returns
Underestimating risk factors- Optimism turns a blind eye to anything that can go wrong. Investors who are under optimism bias often assume that nothing can go wrong when they conduct the business. This false confidence can lead to impractical decisions, often impulsive, which makes them overlook the risks involved.
Excessive trading- Investing more than what you can bear the loss for is a mistake optimism bias can make you do. Excessive trading, commonly known as churning, refers to your transactions exceeding your risk tolerance rates in the portfolio. This is a red flag in trading when the broker or advisor on the stock charges a certain amount on each transaction and then the profit margin reduces, closing to the investment capital itself.
Overestimating returns- A common blindfolded mistake that happens when you’re confident in investing is when you start overcompensating the profit margins because of the past flourishing trades. It is incorrect to expect good returns each time you invest, but overestimating returns can do more harm than good. Every investor plans future investments and there is always uncertainty even with a small investment. Thus, bearing a loss on a falsely predicted transaction can lead to disappointment and disrupt future investments.
Ignoring any contradicting news- Stock investments are live wire trade. Usually, investors have a look at the market rates first thing in the morning. But optimism bias can condition the mind to overlook the present scenarios, no matter how important that is, to tie the expectations from the future. At this stage, the investors ignore and disregard anything which contradicts their investments and show overconfidence in their ability and experience.
Experiencing below-market returns- Research suggests that an average investor happens to earn a total of 5.19% return due to reckless decisions and lose money easily. This is so because instead of making sane financial decisions, investors react emotionally to the market’s nature and fall prey to the overconfidence boost.
To avoid optimism bias, one needs to take down the rose-tinted glasses and look at things as they are. There are ways to avoid such situations where the investor might overcompensate the profits in their heads, only by being optimistic.
- Sit quietly and do nothing at all- If you have planned the investments with long-term goals in mind, it is okay to not look at the stocks every day and worry about the rise and fall of the market. Do not be bothered by it because short-term changes in the market won’t impact the investment’s overall long-term plan.
- Apply scientific methods- Investments result from formulas derived from scientific approaches on the stock market methods. Hence, plan your investments according to these sciences and trust the numbers they provide.
- Do not hurry to sell- When the market is down, do not start selling the equities in a hurry. If you’ve planned the investments in a way that you can sustain till the market settles back, wait it out. Do not rush into making decisions that can impact your long term goals.
Now that we have understood the basics of optimism bias, and how we can avoid it, let's move on to another kind of bias, known as Information-Processing Bias.
Let’s revise the chapter in a few pointers before moving on to the next one!
- Optimism bias refers to measuring things with an uncalculated approach, which results in having an unrealistic positive view of the investment present and future.
- There can be many reasons for optimism bias, major ones being past flourishing returns, the rise of the market, overconfidence and knack for making profitable investments resulting in a superior state of mind of the investor.
- The consequences of optimism bias can be as lethal as excessive trading, experiencing below-market returns and over expectations of return.