Behavioural Finance

ASSIGNMENT

Submitted to: Dr.Divya Verma

Submitted by:
Athul C Sasi
MBA(FA)
01016659419
 TYPES OF
BEHAVIOURAL
BIASES
 1.Loss Aversion Bias
Example:
Imagine you are under medication and you get two options –  an
injection every day for the next 20 days Or an injection, which is 20% more
painful, every day for the next 12 days.

Most of you will prefer option 1, that’s because we tend to remember the
intensity of the pain whereas the duration of the pain/joy is often ignored.
Since under option 2, pain is 20% higher,  we go for option 1.
How to deal with loss aversion bias:
One of the easiest ways to avoid this bias is to adopt an overall portfolio
perspective and not look at investments individually. Different asset
classes perform differently at a time, so if you have a well-diversified
portfolio spread across asset classes, you will have some investments
underperforming while others performing well. And hence on an overall
portfolio level, you will not see extreme losses or volatility. 

Also, it is important to remain aware of loss aversion as a potential

weakness in your investing decisions.
 2.Herd Mentality Bias
Example:
A classic example of herd behaviour occurred in the late 1990s.
Investors followed the crowd and invested in stocks of IT companies,
even though many of them were loss-making and were. Herd
mentality was again seen in 2007-08. 
In both these instances and other examples of herd mentality, it is
often the case that investors’ confidence level peaks with market
levels, and as a result, the largest chunk of money gets invested almost
at the peak of the cycle. And you know what comes after peak – a
fall. 
So if you follow the herd you are almost guaranteed to be left
disappointed.
How do we deal with herd mentality bias:
Two words – Asset Allocation.  Asset classes move in cycles and no single
asset class continues to outperform or underperform. Over the last 20 fiscal
years, equities, debt, and gold have outperformed each other at different
times. So, build a portfolio with an allocation to each asset class. How
much you should put in each depends upon your risk appetite but once you
decide stick to it. 

Asset allocation also ensures you do the opposite of what the herd is
doing. Here is how – as one asset class starts performing, let’s say equity,
the percentage allocation of equity in your portfolio will start going up. So,
to bring back the asset allocation mix to the original level, you will have to
sell part of equity investments. So you book profits while others invest
trying to get returns you would have already made.
 3.Mental Accounting Bias
Example:
Sanjeev is a salaried person and works hard to earn his monthly income.
One day he gets news that one of his uncles has died and that he has left
him a huge amount of money. Now since this money came not from his
hard work, Sanjeev will be more likely to be okay taking risks with it.
That’s because there is an emotional attachment with his hard-earned
money and not with these gains.

Now you might say, I am not like Sanjeev but think about it. How many
times have you stopped yourself from investing a larger part of your salary
in equities since you perceive it as a risky asset class and don’t want to
lose your hard-earned money? But if you get some money you didn’t
expect coming your way, you will be more open to taking risks with it.
How should you deal with mental accounting bias:
The best way, which actually helps you use this bias to your advantage, is
following a goal-based investment approach. Once you attach a goal to a
particular investment, you mentally allocate that money to a particular
purpose.
 4.Availability Bias
Example:
In 2008, the markets crashed and the US S&P 500 index fell 37%. But,
the following year, in 2009, the market bounced back with a return of
26.5%. After 2009 ended, a survey was conducted asking people how they
thought the market performed that year. Likely due to the traumatic events
of the recent crisis, two-thirds of respondents incorrectly thought the
market was down or flat in 2009.
How do you deal with availability bias: 
Well, you need to look past all the noise and then act. For instance,
we are experiencing an unprecedented scenario with Covid-19 and
its impact is being felt across the globe. But before you stop
investing or even redeeming, ask yourself, will Covid-19 grab
headlines one year from now like the way it is doing now? 

Sure, market corrections hurt. But after every fall comes the rise and
if you want to make the most when the markets bounce back, then
look at the fall as an investment opportunity and not a reason to exit.
 5.Recency Bias
Example:
In 2017-18, there was euphoria in the mid and small-cap space. Looking
at the returns of the last couple of years, investors, irrespective of their risk
appetite, invested heavily in the mid and small-cap funds even as space got
overheated. And then came the crash.

This tendency to think that the recent experience will continue into the
future usually leads to disastrous consequences. That’s because if you get
swayed by a recent event, you will either go overweight or underweight in
the asset class which is in favour or out of favour, thus leading to
inappropriate asset allocation. The overall risk in the portfolio also
increases drastically as you will, in all probability swing your portfolio to
extremes during such situations, with the hope that the trend will continue
in future.
How do you deal with recency bias:
The first thing you need to do is accept that lane changing i.e. looking at
the recent track record of returns to keep changing which fund or which
asset class you invest, doesn’t work. An asset class performing well today
might not do well tomorrow.
And secondly have an asset allocation strategy and stick to it.
THANK YOU