Predictably irrational….

Our bias: We believe that more people die in cyclones or earthquakes as opposed to malaria. We remember extraordinary events, hence we feel that they have a greater impact.

  • Economic impact of our bias: Markets crashes, losses, and frauds get a lot more air time – hence there is a prevalent misconception about business. We tend not to consider that the business we work, our friends, colleagues, most people we know are honest and well meaning.
  • Action to overcome this bias for investing: We should consciously look at the regular trends (averages) and keep the extreme events in the right perspective. Extreme events do happen, diversification will help reduce individual firm specific risk, while providing an upside that is enjoyed by the firms in that industry.

Our bias: A loss hurts us twice as much as compared to the pleasure felt for a similar gain.

  •  Economic impact of our bias: This means we tend to make decisions to manage our feelings and hence are risk averse.
  • Action to overcome the bias for investing: We need to quantify the gains and losses and try to make sure that we are not overly swayed by a prospect of loss.
  • Economic impact of our bias: Sometimes we tend not to book a loss (i.e, we tend to hold on to the poorly performing securities) – as booking the loss will make us “realize” the loss in monetary terms.
  • Action to overcome the bias for investing: We need to realize (make a mental adjustment) that holding a security is same as choosing to invest money in that product. We should not hold a security in which we will not be investing today if we had the money.

Our bias: Once we make decisions we tend to find reasons to justify it, we ignore data that may be stating the contrary.

  • Economic impact of our bias: We may be overestimating the profits or underestimating the losses in the investments we hold. This is especially a challenge when we are looking at future prospects.
  • Action to overcome the bias for investing: It is best to use data from multiple sources to make sure we are being objective when we are reviewing our decisions. It will help if we write down the expected performance of the products we invest in so that we are able to review their performance in a more objective manner.

Behavioural economics is fast becoming a field which is giving us an opportunity to understand our behaviour. Dan Ariely‘s , Predictably Irrational and The upside of Irrationality are very interesting and insightful. Undercover economist, Freakonomics, Nudge, What the dog saw, How we decide – are some other interesting books giving insights into our behavior.

Knowledge of our irrationality, biases, and decision making process can be leveraged to help make better decisions.

Happy investing….

 


 IndusWealth:Making your money work for you

About Praveen Reddy

http://in.linkedin.com/in/praveenreddyinduswealth

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