Most investors do not assess risk with numbers; they do it through emotions. Market surges and declines often lead people to give excessive importance to recent events and ignore long-term probabilities. Research in behavioural finance, including the work of Daniel Kahneman and other scholars, shows that biases such as loss aversion, recency, herd behaviour, mental accounting, and overconfidence may distort decision-making and lead to potential mistakes. Here’s a look at what exactly these biases are and how they play out in investing.
Table of content
- Common behavioural biases
- How probability gets distorted in real life
- A practical bias-aware decision path
- Reading disclosures the right way
Common behavioural biases
Loss aversion
A decline in value often feels more painful than an equivalent rise feels pleasant. This tendency may lead investors to hold underperforming investments for too long, exit strategies prematurely, or avoid equity exposure even when their goals and time horizons allow it. Loss aversion is one of the main reasons for poor timing decisions such as selling in panic or buying in euphoria.
A practical way to counter this bias is to pre-commit to a process. Map financial goals to time horizons, decide an acceptable drawdown range in advance, and record rebalancing triggers. If investing in mutual funds, the scheme’s risk level is clearly represented in the Riskometer – ranging from low to very high – which may help investors understand how much volatility to expect in their investment journey. This may, in turn, put market fluctuations in context.
Recency bias
When the market performs well for a while, investors often expect that trend to continue. The opposite may happen after a downturn. Investors sometimes pick stocks based on recent rallies or short-term excitement rather than careful analysis. It is important to remember that past performance may or may not be sustained in the future.
Guardrails that may be suitable include using calendar-based reviews instead of performance-chasing. Rebalancing to target allocations at predefined intervals may help trim outperforming holdings and add to those that have lagged, consistent with the investor’s stated risk tolerance.
Herd behaviour
When peers or media discussions highlight a particular investment, it may feel reassuring to follow the crowd. However, collective behaviour often takes place after a strong rally or during widespread fear. Copying others may lead to overpaying during periods of optimism or exiting hastily during market declines.
A simple approach is to ask, “Would I make this investment if I did not know what others were doing?” Writing down the independent reason for each investment, including its goal, horizon, risk label, and role in the portfolio, may help reduce reliance on external opinions.
Mental accounting
Many investors divide their money into separate mental “buckets” and judge each in isolation. This may cause them to overlook concentration risks across their entire portfolio. Investor education programs often encourage reviewing all holdings together across equity, debt, and hybrid categories.
Creating a one-page portfolio summary that lists each holding, its category, indicative risk level on the Riskometer, and its purpose (potential growth, income, or relative stability) may improve judgment. A comprehensive view improves judgment because it helps in evaluating the combined effects, not mere fragments.
Overconfidence
Some investors believe outcomes depend mainly on their personal insight rather than chance. Excessive trading and ignoring diversification may stem from this misplaced confidence. Overconfidence may also increase transaction costs and tax liabilities.
A useful antidote is to record what could go wrong for each investment and how you might respond. Using a checklist that reviews costs, liquidity, credit quality (for debt categories), and concentration before investing may help strengthen decision-making discipline.
Read Also: The Hidden Psychology Behind Your Money Habits
How probability gets distorted in real life
Extreme events often feel either impossible or inevitable. After a long period of calm, investors may underestimate the possibility of market corrections. After a sharp fall, they may expect crashes frequently.
Percentages without context can also mislead. A fund marked as “very high risk” on the Riskometer is not a prediction of loss. It is a disclosure of potential volatility relative to other categories. Reading it as a probability of failure is a common misunderstanding that the risk framework aims to reduce.
Time horizon also influences risk perception. Debt-oriented categories generally aim for relatively lower variability over shorter horizons, while equity-oriented categories are typically considered for long-term goals given their return-volatility trade-off.
A practical bias-aware decision path
- Define the financial goal and time horizon first – is the goal to accumulate near-term cash or long-term wealth?
- Select the category based on suitability, not on stories or recent trends. Decide whether equity, debt, or hybrid exposure may be appropriate based on your time horizon and tolerance for fluctuations before looking at performance data. Generally, for shorter horizons, debt investments are more suitable. Longer horizons, meanwhile, give more time to potentially ride out equity volatility.
- Automating rebalancing through calendar-based or threshold-based rules may help counter recency bias and reduce the impulse to react to short-term market movements.
- Limiting unnecessary market monitoring may also help, as frequent portfolio checks can exaggerate perceived risk. Investor education advisories often recommend periodic reviews instead of daily tracking.
- Documenting investment decisions by noting the reason for entry, expected role, and exit conditions may improve accountability and reduce herd-driven shifts.
Read Also: The Psychology of Smart and Intentional Spending
Reading disclosures the right way
Risk labels, offer documents, and factsheets provide important disclosures on risk, costs, and portfolio characteristics. These documents are intended to help investors assess alignment with their own time horizon, cash flow needs, and tolerance for volatility. They do not predict future outcomes. Offer documents and Key Information Memorandums (KIMs) should be read carefully before investing.
Common thinking traps to be aware of include:
- “It went up last quarter, so it will keep rising.” This is recency bias; use pre-decided rebalancing guidelines instead.
- “Everyone I know is buying this theme.” This is herd behaviour; verify whether it aligns with your financial goals and risk category.
- “I will exit at the first sign of trouble.” This may be loss aversion; pre-decide acceptable drawdown limits.
- “One investment is performing well, so I am fine.” This reflects mental accounting; evaluate your entire portfolio instead.
Conclusion
Risk perception is shaped as much by psychology as by numbers. Recognising behavioural patterns that distort judgment and applying practical measures such as category selection, periodic rebalancing, and disciplined use of risk disclosures may help investors make decisions that align more closely with their goals and tolerance for volatility.
At Bajaj Finserv AMC, we recognise that emotions are the cornerstone of investor behaviour – not just for investors but for investment professionals too. That’s why, behavioural finance is at the heart of our investment philosophy, InQuBe, which combines the Information Edge, Quantitative Edge and Behavioural Edge. By understanding, tracking and monitoring market sentiments and our own investment biases, we seek to make mindful and strategic investment decisions. Get the Behavioural edge by investing with Bajaj Finserv AMC. Read more about InQuBe here.
