Understand the biases: Pogo, the folk philosopher created by the cartoonist Walt Kelly, provided an insight that is particularly relevant for investors, we have met the enemy and it’s us. So, understand your biases (the enemy within) as this is an important step in avoiding them.
Focus on the Big Picture: Develop an investment policy and put it down on paper. Doing so will make you react less impulsively to the gyrations of the market.
Follow a Set of Quantitative Investments Criteria: It is helpful to use a set of quantitative criteria such as the price-earnings ratio being not more than 15, the price to book ratio being not more than 5, the growth rate of earnings being at least 12 percent, and so on. Quantitative criteria tend to mitigate the influence of emotion, hearsay rumor and psychological biases.
Diversify: If you own a fairly diversified portfolio of say 12 to 15 stocks from different industries, you are less prone to do something drastically when you incur losses in one or two stocks because these losses are likely to be offset by gains elsewhere.
Control Your Investment Environment: If you are on a diet, you should not have tempting sweets and savories on your dining table. Likewise if you want to discipline your investment activity, you should regulate or control your investment environment. Given below are some ways of doing so:
1. Check your stocks only once every month
2. Trade only once every month and preferably on the same day of the month
3. Review your portfolio once or twice a year
Strive to Earn Market Returns: Seek to earn returns in line with what the market offers. If you strive to out perform the market, you are likely to succumb to psychological biases.
Review Your Biases Periodically: Once in a year review your psychological biases. This will throw up useful pointers to contain such biases in future.
The central assumption of the traditional finance model is that people are rational. The behavioral finance model, however, argues that people often suffer from cognitive and emotional biases and act in a seemingly irrational manner.
The important heuristic driven biases and cognitive errors that impair judgment are: representativeness, over confidence, anchoring aversion to ambiguity and innumeracy. Representativess refers to the tendency to form judgments based on stereotypes. People tend to be over confident and hence over estimate the accuracy of their forecasts. Thanks to anchoring, also called conservatism people are often unwilling to change an opinion even though they receive new information that is relevant. People are fearful of ambiguous situations where they feel that they have little information about the possible outcomes. People have difficulty with numbers.
Proponents of traditional finance believe that framing is transparent implying that investors can see through all the different ways cash flows might be described. In reality behavior tends to be frame de-pendent. This means that the form used to describe problem has a bearing on decision making. Frame dependence stems from a mix of cognitive and emotional factors.
The prospect theory describes how people frame and value a decision involving uncertainly. People feel more strongly about the pain from a loss than the pleasure from an equal gain about two and half times as strongly. This phenomenon is referred to as loss aversion. Because of loss aversion, the manner in which an outcome is described either in the vocabulary of gains or the vocabulary of losses has an important bearing on decision making.
Traditional finance holds that wealth in general and money in particular must be regarded as ‘fungible’ and every financial decision should be based on a rational calculation of its effects on overall wealth position. In reality, people tend to separate their money into various mental accounts and treat a rupee in one account differently from a rupee in another because each account has a different significance to them.
Ideally, investors should pay attention to changes in their total wealth over their investment horizon. In reality, however, investors engage in ‘narrow framing’ – they focus on changes in wealth that are narrowly defined, both in a cross sectional as well as temporal sense. Since people are loss averse, narrow framing leads to myopic risk aversion.