Stock market: Keep your emotions in check in the market

Investors should quantify the risk-reducing and return-enhancing advantages of diversification and proper asset allocation.

As investors across the country are celebrating Sensex crossing the 60,000-mark, it is essential to see what are the emotional biases and how one should conquer them. Empirical research has confirmed that generally investors who attempt to time the stock market, get into the market at the top and flee at the bottom. In this article, let us discuss dealing with emotional biases in detail.

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What are emotional biases?
Most of the investment science literature theories assume that individual investors act rationally and consider all available information in their stock selection process and so the stock markets are efficient. But the behavioural finance literature challenges these assumptions and explores how individuals as well stock markets actually behave. Emotional biases are related to feelings, perceptions, or beliefs about elements, objects, or the relations between them, and can be a function of reality or of the imagination. In the world of investing, emotions often cause investors to make suboptimal decisions.

Dealing with endowment bias
This bias is an emotional bias in which investors value an asset more when they hold rights to it than when they do not. So, investors may irrationally hold on to securities they already own, a bias particularly true regarding their inherited investments. For example, an investor might hold on to an inherited portfolio due to their emotional attachment. In such a scenario of inherited investments, investors should ask themselves that if an equivalent sum to the value of the investments inherited had been received in cash, how would they invest the cash. Often, the answer is a very different investment portfolio than the one inherited.

Handling loss-aversion bias
It is a bias in which investors tend to strongly prefer avoiding losses as opposed to achieving gains. This type of bias leads investors to hold their loss making shares even if it has little or no chance of going back up. Empirical studies suggest that psychologically, losses are significantly more powerful than gains. This bias also leads to selling investments in a gain position earlier than justified by fundamental analysis. Investors sell winning investments because they fear that their profit will erode. In such a scenario, investors should re-assess the intrinsic value and decide accordingly.

Dealing with regret-aversion bias
It is an emotional bias in which people tend to avoid making decisions that will result in action out of fear that the decision will turn out poorly. Thus, investors try to avoid the pain of regret associated with bad decisions. Investors are reluctant to sell their holdings because they fear that the position will increase in value and then they will regret having sold it. To overcome regret-aversion bias, education is essential.

Investors should quantify the risk-reducing and return-enhancing advantages of diversification and proper asset allocation. So, investors should recognise and understand that losses happen to everyone and keep in mind the long-term benefits of including some risky shares in their portfolio.

Investors should recognise that the biases discussed above exist and understand that they are likely to exhibit some of them. This is the first step in correcting the mistakes and avoiding similar wrong turns in the future. Another way is to adopt a scientifically tested and proven investment strategy and be ruthless in applying the same in managing their portfolio. Thus, investors can make investment-decisions based on facts and figures rather than intuitions and feelings.

The writer is a professor of finance & accounting, IIM Tiruchirappalli