What corrupts your investment decisions?

“We look at the most recent evidence, take it too seriously, and expect that things will continue in that way ...Things go up and up and up, and we start thinking it has to always go up.”

-Dan Ariely, author of the book Predictably Irrational.

Do you think the same (up...up...up) for the returns from Stock Market and perhaps even Bitcoin and the opposite (down...down...down) from Fixed Deposits (FDs) and Real Estate?

Does this sound familiar - "FDs are not giving returns so I want to break my FDs and invest that money in stock markets for higher returns".

If it is so then your investing decision may have been corrupted by your own biases!

This particular one is called Recency Bias. It is our tendency to believe what has happened in the recent past is more likely to happen again (and keep happening). Moreover, the inverse is also true that what has not happened in the long time, is less likely to happen in the near future.

For example, in the last 5 years, the interest rate on FDs has come down from approx 10% to about 6% now. In the same time, the stock market (Sensex) has gone up from 17,000 to about 33,000 now. We tend to think that this will "always" keep going like this. Here, we may also think that the events like 2008, when the stock market came down from about 21000 to 8000 is a thing of past and unlikely to happen again, “ever”.

Recency Bias, like many other cognitive biases, has been important for our survival from an evolutionary perspective. For example, when we were hunters and saw our prey near a waterhole, we would keep going at that spot regularly to hunt for our survival.

But when it comes to investing in the stock markets (which are highly unpredictable), the same bias can be quite detrimental. Due to this bias most of the times people end up chasing past returns. They sell their investments which have not been doing well in the recent past (FDs, Real Estate) and re-invest their money where returns have been higher in the same period. This leads us to invest when prices are high and sell when prices have gone down - the very opposite of buy low and sell high mantra that all of us aspire to adhere to. If you keep doing this, like the physics genius Newton, you may go broke too! (See Newton's investing nightmare below).

Can you learn from Newton and avoid repeating the same mistake in your own investing journey?

To protect yourself from the effect of Recency Bias, it is prudent to invest with proper allocation between FDs/Debt funds and Equity funds based on your risk taking capacity and time horizon of your investment. Higher the risk taking capacity and longer the time horizon, more money should be invested in equity funds.

Further, despite proper asset allocation, if it becomes too difficult to control this bias, take professional advice or just take your emotions out of the picture by using a data driven investment system.

At Goalwise, we have already implemented data driven strategies to minimize the role of such cognitive biases in your investment decisions. You can login to your Goalwise account and check out our Goal Planning Tool for different goals like Retirement, Children, Vacation. You will observe that as your time horizon and risk taking capacity increases, Goalwise increases allocation to Equity Funds and vice versa.

Further, as part of its automated Portfolio Re-balancing, if the market goes up, it suggests to prune down investments in Equity funds to re-invest that money into Debt funds. This way it helps you stay invested as per your risk profile (neither taking higher risk nor lower than required).

We were not there to help Newton then but certainly, we are here to help you and make your investing journey smarter than his! :)

P.S: If, after reading this blog, you have started predicting stock market will go down just because it has gone up in the recent past (it may, it may not) then that’s another bias influencing you (Anchoring bias) but more about it next time!