Learn how to overcome biases

One of the first assumptions of traditional economic theory is that humans are rational creatures and will make a choice which maximises value. Simple observation of human behaviour will prove otherwise and nowhere is it more visible than in equity investing.

A friend of mine –Arvind, asked me to accompany him to a mall, where he wanted to buy a shirt he really liked on his last visit to the mall but had failed to pick up. After five minutes in the mall, Arvind decided to leave without purchasing the shirt. On enquiring as to the reason for his abrupt departure, he said that the same shirt was available at a 25 percent lower price the last time he had come to the mall. The store had increased the prices since his last visit and he was no longer interested in buying that shirt at a substantially higher price. All very rational.

Recently I got a call from Arvind again saying that he had purchased shares of a large Engineering company he had been observing for the last six months. On seeing the share price go up by 25% in last one month, he decided to buy the stock hoping it goes up further. The fact that similar to that shirt the same asset was now available at a 25% higher price seemed irrelevant. Arvind’s behaviour of buying a stock after it has rallied is not unique but is in fact a common bias observed across equity investors. Behavioural scientists now call it recency bias (extrapolating recent events like a stock price surge into the future). The same bias leads to investor participation dramatically increasing in extremely bullish markets, often leading to their downfall.

So how does one overcome this bias? A simple approach is to have a predetermined value of any asset (based on its future cash flow generating ability) and to buy it when it is available at a large discount to that value. Similar approach should be used to selling investments i.e, selling it when it is trading at premium to its predetermined value. Our approach to equity investing in Quantum Mutual Fund remains very similar. We have a predetermined Buy and Sell limit for each stock actively covered by our research team. The limits are decided based on sustainable cash flow generating ability of a company and its long term valuation bands. Once a stock hits our buy limit it finds its way into our portfolio and once it hits our sell limit it exits our portfolio. We believe this simple approach allows us to limit biases in investing and create a portfolio based on long term fundamentals.

Above article is authored by Quantum.

View All