pessimism bias among investors

Investor behaviours to avoid: Pessimism Bias

Some people tend to focus more on the negative than the positive. While this may play havoc in their personal lives, it can definitely change the way they view investing and money management.

Investors with pessimism bias typically miss opportunities that stock markets or other asset classes provide from time to time. These investors typically focus more on the possible negative experiences or outcomes and not on the possible positive experiences or outcomes. As a result, they might not be able to take advantage of buying different asset classes such as stocks, mutual funds, real estate, etc., when valuations are attractive on account of the prevailing pessimism in those asset classes.

For example, during bear markets several stocks are available at lower prices. The wise investor would snap these up believing they are getting a great deal. However, a person with pessimism bias may think that stock market’s dismal performance would continue and as a result miss out on this opportunity.

For example, in September 2013, when the Rupee touched Rs.68.60 against the dollar there was a lot of pessimism about the prospects of the Indian stock markets and investors who remained pessimistic might have avoided/missed the attractive investment opportunities at that time. Investors who avoided falling prey to pessimism bias and took advantage of the attractive investment opportunities by taking a more balanced view would have generated attractive returns, as the key index Nifty itself has generated nearly 48% return.

Investors with pessimism bias could also avoid taking risks as they are not positive about the future outlook, and thus, they try to avoid losses that can occur due to investing in stocks or real estate. This strategy could also lead to sub-par returns for the investors, especially when investors miss the potential upside opportunity of investing in stocks or real estate because of their pessimism bias.

While investing in the stock of a company, the value of the company is derived not only based on the current worth of the company but is also based on its future prospects. As the future prospects of the company are dependent on the developments in the economy/industry/company, various scenarios might play out based on these future outcomes. Investors with a long term time frame would be better placed to invest based on a more balanced, realistic scenario instead of going by the most optimistic or pessimistic scenario.

While pessimism bias adversely affects the investor results most of the times, it might also lead to better results, especially if the investor acts with pessimism bias when there is universal optimism in the stock market or the real estate market. Typically, when there is lots of optimism in the market, the valuations are expensive and during these times, investors might get better results if they avoid investments on account of pessimism bias.

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