How To Avoid Financial Losses: How to avoid financial losses: Take a look at these 6 Daniel Kahneman principles | Business

Human beings are considered to have superior cognitive abilities among all species. However, our capacity to make good decisions is often challenged by life’s complexities. Psychologist and Nobel laureate Daniel Kahneman, who recently passed away at the age of 90, emphasised that making sound decisions is not as simple as it seems.
Kahneman noted that we often rely excessively on intuition when we should engage in deeper analytical thinking, especially evident in financial decision-making.ET analyzes six Kahneman principles to follow to assist investors in avoiding significant financial losses.

Beware of the Halo Effect

Investors often develop a strong liking for certain individuals or management teams. For example, Asian Paints has become a favorite among fund managers who prioritize ‘quality’ as their main criterion, states the financial daily’s report. These companies typically have high price-to-earnings (PE) ratios, leading to a ‘halo effect’ perception that they will consistently provide high returns regardless of their valuations. However, Asian Paints’ performance over the past year has only seen a modest 2% increase compared to a 30% rise in the broader market index, Nifty. Over five years, Asian Paints has underperformed the Nifty, with the company’s PE ratio declining from 98x to nearly 50x.
As valuations adjust, the ‘halo effect’ may diminish, resulting in missed investment opportunities. Despite this, some fund managers remain optimistic, expecting the quality premium associated with the ‘halo effect’ to eventually return.
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Avoid the law of small numbers

Drawing significant conclusions about a stock based on limited data or a small sample size is risky. While there’s a common belief that small companies offer better returns compared to large caps, this isn’t always true. Many small-cap companies actually provide low returns. Often, investors focus on a small group of successful small and mid-cap companies, leading to the misconception that all small-cap investments are winners. However, this overlooks the reality that there are also many underperformers in this category. It’s important to consider a broader range of data and not just focus on a select few success stories when making investment decisions.

Don’t succumb to sunk cost fallacy

Continuing to invest in something even after its peak performance is a common mistake. For instance, in 2018, investors in YES Bank stock persisted in buying during downturns, hoping for a turnaround. However, this optimism was misplaced as the bank’s performance continued to decline over an extended period.

Question the illusion of pundits

Trusting popular commentators who claim to predict market trends is a common pitfall. For example, some investors put their faith in a highly charismatic and articulate fund manager in the Indian market. They believed that his exceptional ability to explain valuations would lead to superior returns. However, despite these expectations, all of his funds have consistently performed poorly over the past one, two, and even three years.
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Overcome loss aversion

Choosing certainty of returns, even if they are lower, over the potential for higher returns with a slight risk of loss, is a common tendency among investors. For example, a typical LIC money back policy offers returns of less than 6%. Investors are averse to losses and are aware that the pain of losses is more significant than the joy of gains. Therefore, they often opt for investments with lower but guaranteed returns, such as fixed deposits, gold, and sometimes real estate, where the risk of losses is perceived to be low. Even when investing in stocks, they prefer companies known for their stability and minimal risk of losses.

Guard against overconfidence

Many traders fall into the trap of overconfidence, believing that they are immune to losses. A study by Sebi reveals that 90% of derivative traders end up losing money. Despite this statistic, many traders operate on instincts, convinced that their past successes in other areas will translate to success in derivative trading. However, the reality is that they often end up losing money. This overconfidence is not limited to amateur traders; even professional traders and investors can become victims of their own hubris. They may neglect their risk management systems and rely too heavily on instincts, abandoning rational, process-driven decision-making.