Tuesday, 2 September 2008

Strategies for Overcoming Psychological Biases

The field of behavioural finance highlights many psychological biases can impair the quality of investment decision making. Here are some strategies for overcoming the psychological biases:

1. Understanding 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.

2. 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.

3. Follow a Set of Quantitative Investment 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 not more than 5,
  • the growth rate of earnings being at least 12%, and so on.
Quantitative criteria tend to mitigate the influence of emotion, hearsay, rumour and psychological biases.

4. 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.

5. Control Your Investment Environment

If you are on a diet, you should not have tempting sweets and savouries on your dining table. Likewise, if you want to discipline your investment activity, you should regulate or control your investment environment. Here are some ways of doing so:
  • Check your stocks only once every month.
  • Trade only once every month and preferably on the same day of the month.
  • Review your portfolio once or twice a year.

6. Strive to Earn Market Returns

Seek to earn returns in line with what the market offers. If you strive to outperform the market, you are likely to succumb to psychological biases.

7. Review Your Biases Periodically

Once in a year, review your psychological biases. This will throw up pointers to contain such biases in the future.

No comments: