Three behavioural biases that can ruin your portfolios

Awareness & consciousness of the biases would prevent one from stepping on the banana peel of wrong conclusions.

We all think we are rational beings and we take decisions or arrive at conclusions after weighing the pros & cons of the situation. We also take into account all the data available before arriving at a decision or conclusion. But, still, many of the decisions or conclusions we take turn out to be really wrong, which leaves us scratching our heads. We wonder - Where have we gone wrong?

It is not that we may actually be wrong, but there are entrenched thought patterns which may lead us astray. We may not even be conscious of this!

We need to understand first where the biases are coming from & what some of those biases are. Only when they understand that, can it be tackled.

Hindsight Bias – We are not oracles or soothsayers. Hence, we would not be able to anticipate which events will happen or how it will unfold. But after the event, it all seems so logical and even cogently explainable. This is irrespective of how improbable they thought the event was, before it occurred.

Psychological experiments prove this. Baruch Fischhoff demonstrated this “I knew this all along” effect, through an experiment. Fischhoff conducted a survey on possible outcomes of Richard Nixon’s trip to Russia & China in 1972 and asked people to assign probabilities to various events, before the trip. When the trip was done & he went back to the same people, there were surprises in store.

Whichever event had actually occurred, people exaggerated the probability they had assigned to that event. If it did not happen, people said they always felt it would not happen (though the probability they assigned before that event was higher )! After the event, everything seems so logical & plausible, that we automatically adjust our memory to align with what is now known!

Hindsight bias has huge implications for all of us. For instance, if during a routine surgical intervention an unpredictable accident caused the death of the patient, it will most probably be believed that the doctor did not assess the situation properly & went in for a risky procedure! The benefit of hindsight & knowing the outcome alters how people perceive what the doctor had done. We come to the wrong conclusions due to hindsight bias!

There is also another bias lurking out there. It’s called outcome bias.

Outcome bias – Blaming someone for a good decision which worked out badly & giving too little credit for good moves, that, with hindsight, looks all too obvious, is outcome bias in action. When outcomes are bad, people would blame the decision makers for not seeing the writing on the wall, in spite of prudent decisions that the person might have made with the information available, at the time of the decision.

This again is proved in psychological experiments. In case of 9/11 type incidents, the officials concerned seem negligent, even absolutely irresponsible after the event. CIA had intelligence inputs to indicate that Al Qaeda was planning a major attack, which went to the National Security Adviser. This was not escalated to the President, which was questioned after the event. It did not go to the President as it was one of the many intelligence inputs that CIA got and this one did not look specifically significant.

Predicting outcomes is extremely difficult as there are so many variables affecting an outcome. And yet, after the outcome is known, we all tend to judge all those who were involved in that process, based on how it turned out!

Action Bias - There is another important area where we all go wrong.

Financial advisors are expected to keep shuffling portfolios or keep doing something, in their quest to advise clients. That is why advisors who tell their clients to just stay invested or tell the clients that no changes are needed in their portfolios, are not that popular. People like action. Those that are constantly seen to be taking action are seen as dynamic & proactive. This is called the action bias.

The good advisors who advised clients against unwanted churn are not fully recognised for their wisdom, even if they ended up with good returns. The client thinks that the markets have done so well that the returns they have got would anyway have come and advisor contribution is not much (the advisor did not even suggest any actions in between and asked us to stay put). Even a very good outcome can act against a person. This is a case where outcome bias & action bias are acting in concert.

Action bias is seen even in sports. In a penalty kick, there is a penchant for the goalie to jump to the left or right without knowing the intention of the kicker. Had the goalie been standing in the middle, he would have probably saved more goals. That’s what studies suggest! The goalie does not want to be seen as slothful & the viewers equally expect him to dive to the left or right, instead of planting himself in the middle. That is the classic action bias at work!

What can we do - Knowing that these biases exist is helpful, but that knowledge by itself cannot prevent these biases from asserting themselves.

Before coming to any conclusions, one needs to examine whether it is tinged with any bias that may lead one astray. Awareness & consciousness of the biases would prevent one from stepping on the banana peel of wrong conclusions. Wrong conclusions lead to more wrong decisions. Mind does play games - but we can avoid being kicked around, if we are alert.

Article first published on:
Moneycontrol - Three behavioural biases that can ruin your portfolios

Author  -   Suresh Sadagopan  | Founder | www.ladder7.co.in

#SureshSadgopan #FinancialPlanner #FinancialAdvisor #Fiduciary #LifePlanning #FeeOnly #HolisticAdvice #Ladder7