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Behavioural Biases And Their Effects on Investment Decisions Series – Part 5

Psychology plays a significant role in the mechanism of investment; and psychology gets largely affected by the behavioural biases. The investors are highly prone to get affected by the biases and take decisions that may end up making them pay heavily. Any interferences or pitfalls in the cognitive process of investment may lead to not so wise decisions. One such behavioural bias is the Halo Effect Bias.

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Halo Effect Bias
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Halo Effect Bias

Halo Effect is a cognitive bias which makes a person judge a person, product, or company based only on one or few characters of the person, product or company. It is the tendency which causes influence on one area, based on the impression created in another unrelated area.

Halo effect is seen to be applicable in many areas of life. It makes people judge other people based on few characteristics. For instance, a supervisor may end up evaluating his subordinate based only on one feature, say punctuality and timeliness, and ignore all other characteristics of him, positive or negative. Similarly, in terms of companies, Apple has created such a halo effect that any product launched by it is successfully accepted, irrespective of the actual reviews of the product.

In the same way, halo effect bias has its implications in investment decisions. A trader with halo effect bias judges a company or a stock only on the basis of certain characteristics and ignores the others. As an example, the companies with known ticker symbols like Microsoft and Apple tend to trade at higher values than the lesser known ones.

Causes of Halo Effect Bias

The main cause of the halo effect bias is the inherent need for the individuals to make quick decisions. Humans are conditioned in a way to make snap decisions when faced with unfamiliar situations. When faced with such situations, traders make quick decisions based on the information they already have and it gets translated into halo effect. Such decisions may not always be right.

Halo effect bias is a more deep-rooted form of confirmation bias. It makes the bearer search for and interpret information in a way that confirms his preexisting beliefs. The confirmation bias makes the trader consider only one aspect of the situation and extrapolate it to the complete situation. The trader takes one positive signal and forms a positive impression of the entire investment. Then, in order to confirm this belief, he interprets the other factors around the investment positive too.

Effects of Halo Effect Bias

The halo effect bias impacts the process of investment in multiple ways. It makes the trader take investment decisions quite irrationally and illogically. The traders affected by halo effect tend to make judgements about a stock or a company based on just one report of the company. If the first report encountered by them gives a buy signal, they act based on the positive halo effect and disregard all other negatives that may be associated with the company or stock.

The halo effect bias has more negative impact on the novice investors. They tend to get affected by their recent wins in the bull markets and create a halo about their own positives. It makes them overconfident and take more risks. When the correction occurs, they end up paying for it.

The halo effect can become a trap for the investors. Instead of choosing an investment opportunity based on their research, they make decisions based on their biases and halo effect. It clouds their judgement. If they have a positive predisposition towards a company, the halo effect bias will make them more prone to have a positive bias towards all aspects of the stock. This can become a very costly mistake.

How to Overcome the Halo Effect Bias?

Halo effect bias is a cognitive bias and is deep rooted into the psychology of an investor. It is difficult to eliminate it completely, however, many steps can be taken to overcome it to an extent that it does not cause too much damage.

The most important advice is to look at a company holistically. Even when the investor has a positive outlook towards a company, he should second-guess himself and keep looking for scenarios that may go wrong. This will help him overcome the initial halo effect he had for the company. He will be able to find out exactly where the company stands, and not just how the company looks from where he sees it.

It is also critical for the investor to do his pwn research and analysis, rather than being dependent on someone else’s analysis. The investors should not rely on tips given by the experts and form an opinion. The decisions must not be taken based on how other investors or the experts see the stock or the investment.

Therefore, it is extremely important for the investors to overcome the behavioural biases to ensure that their process of investment is as rational and as objective as possible.