by Arnav M, Tushar J, Kunjam K, Lavesh D, Neiladri C, and Vir Dadha
Source: Jacob Wackerhausen / Getty Images
Summary. Behavioural economics is an interdisciplinary area that integrates psychology and economics to investigate the impact of cognitive biases, feelings, and social forces on financial market investors. Behavioural finance demonstrates that people may not necessarily be basing their decisions on a rational analysis of all available information. Studies have described how our emotions can deeply affect our monetary preferences -in a well-known experiment by Daniel Kahneman and Amos Tversky, it was found out that losses were more significant than profits. A deep understanding of behavioural finance is essential in dealing with financial matters so that we are able to make better choices by understanding these prejudices.
The study of the influence of various psychological factors on the behaviour of investors or financial analysts is called behavioural finance. It also includes the subsequent effects on the markets - it focuses on the fact that investors are not always rational, have limits to their self-control, and are influenced by their own biases. Let’s move to history now…
The concept of behavioural finance dates to 1912 when George Seldon published “Psychology of the Stock Market”. However, the theory gained popularity and momentum only in 1979 when Daniel Kahneman and Amos Tversky proposed that most investors tend to make decisions based on subjective reference points rather than objectively choosing the best option
The established concepts…
Unlike traditional finance theories, which assume that individuals are perfectly rational and always act in their best interest, behavioural finance recognizes that investors are influenced by cognitive biases, emotions, and social factors. Here, we will delve into the various ways psychology influences investing, providing perspectives and examples to illustrate these concepts.
Mental accounting is the tendency to treat the same thing – money, in particular – differently depending on where it came from or what we intend to do with it.
Imagine an investor called Tushar, who has received a $9000 year-end bonus from his employer. He also has $9000 in his savings account that he has been diligently saving for emergencies and investing in Mutual Fund SIP over the past few years. He categorizes the $9000 bonus as "extra money" or "fun money" because it feels like an unexpected reward. While views his $9000 savings as "safety money" or “high value money”.
Another example of mental accounting is the greater willingness to pay for goods when using credit cards than cash as swiping a credit card means that you can repay the credit card company later.
Confirmation biases are those biases where the brain tries to simplify the information after receiving it and interpreting it in a way which matches their existing beliefs or learnings
Problems related to attention: Since attention is a limited resource, people have to be selective about what they pay attention to in the world around them.
Now consider an investor, Lavesh, who heavily follows tech news and constantly monitors tech stocks. He regularly checks headlines and social media buzz about technology companies. Since he pays more attention to social media, he may overlook important developments of the tech industry or broader economic indicators that could impact the stock price of these tech companies.
Herd mentality bias refers to investors' tendency to follow and copy what the crowd or other investors are doing. They are largely influenced by emotion and instinct, rather than by their own independent analysis.
Two of the major global crises were caused due to herd mentality.
One of them was the dot com crash where many of the dotcom companies did not have financially sound business models, but investors bought into them because everyone else was buying into them having the belief that they could only go up.
Emotions in investing: It refers to decision-making based on extreme emotions or emotional strains such as anxiety, anger, fear, or excitement. Oftentimes, emotions are a key reason why people do not make rational and apt choices while investing.
Fear often manifests during periods of market volatility or downturns, leading investors to sell their assets and shares out of panic, even when it may not be the best course of action. A similar situation occurred during Russia-Ukraine war when investors started panic selling due to the fall of short term stock prices .In the same way, greed can also drive investors’ decision as they may invest more into the market in expectation of high returns when the market is already in a bull run.
Anchoring is a mental shortcut in behavioural finance that describes the subconscious use of irrelevant information, such as the purchase price of a security, as a fixed reference point (or anchor) for making subsequent decisions about that security.
For example, when shopping for a new laptop, if the salesperson shows you an expensive model first, it can anchor you to a higher price point and make other phones seem more reasonably priced, even if they are still expensive. The same thing might also happen while investing.
Biases relating to behavioural finance
Experiential (or recency) bias occurs when investors' memory of recent events or time makes them biased or leads them to believe that the event is far more likely to occur again. Hence the name recent bias
The financial crisis in 2008 and 2009 led many investors to exit the stock market. Many had a dismal and negative view of the markets and likely expected more economic hardship in the coming years. The experience of having gone through such a negative event increased their bias or likelihood that the event could re-occur. In reality, the economy recovered, and the market bounced back in the years to follow with no such experiences in the future again
Loss aversion in behavioural economics or finance refers to a phenomenon where a real or potential loss is perceived by individuals as psychologically or emotionally more severe than an equivalent gain. For instance, the pain of losing ₹10,000 is often far greater than the joy gained in finding the same amount. Therefore, even small losses of such kind of investors might lead them to invest more in the market so as to recover the losses
Overconfidence reflects when investors overestimate their abilities or trading skills and make decisions forgoing factual evidence. This kind of tendency also makes people believe that they have more control over the outcomes than they actually do leading to risky and ill logical investments on a whole
In Familiarity bias, investors sometimes tend to invest in assets or shares of only those companies with which they are familiar or known to from a longer period of time such as the domestic or family-owned companies. In such a situation, the investors’ portfolio is not diversified across different sectors, companies or investments which reduces their risk but makes their portfolio over dependent on a single company.
Source: CFA Institute
How does understanding behavioural finance help us?
A lot of unqualified people think that they cannot generate wealth in the stock market as they are not highly qualified and tend to know less about finance. Most of these people belong to professions which do not involve finance. Understanding behavioural finance helps all potential and current investors as they realize understanding investor psychology is paramount. This helps such people to participate in the wealth creation process and also helps in increasing the overall financial inclusion in the world.
The stock market can also swing wildly since sometimes everyone gets spooked and acts illogically together. Thus, studying how people think poorly about investing can help a potential investor avoid those mistakes.
Investors frequently base their decisions on their age. Younger people may be more ready to take larger and higher risks since they have more time for their money to increase. Older investors, on the other hand, would rather sell their holdings seeing a slump trying to safeguard their savings.
However, behavioural finance views emotions as problems which must be fixed in the long term but, humans have always had emotions in them and they have guided humans to take action and avoid dangers. Investors should realize that they do not need to abandon their emotions. Instead, they should try to optimize them and take cues from them but make the final decision in a rational manner.
People sometimes tend to overestimate their knowledge and abilities; they believe that they are more knowledgeable and skilled than they actually are. Imagine you are at a casino – you might see someone on a winning streak and convince yourself you can replicate their success, completely overlooking the element of chance and the casino’s advantage. This can lead investors to trade too frequently, make risky choices, missing out on better opportunities and ignoring valuable information.
Strategies for Overcoming Behavioural Finance
Behavioural finance has a significant impact on investment performance, it is increasingly being seen as a crucial component of decision-making processes. The primary goal of studying behavioural finance is to reduce or eliminate psychological biases in investor decisions.
An in-depth analysis of behavioural finance literature suggests that its effective implementation can significantly reduce errors for successful investors. Psychological factors heavily influence investors' decisions, necessitating safeguards to overcome mental obstacles when trading stocks and mutual funds. Adopting a disciplined trading approach is crucial for managing these psychological barriers across all investor types.
Stock Investment - A targeted investing strategy must be implemented over an extended period of time to prevent investors' mental mistakes. Investors should maintain thorough documentation of each individual stock they buy for their portfolio. Investors should also choose particular standards prior to deciding whether to purchase, sell, or hold a security.
Before buying any security, every investor must also have answers to these questions:
Why do investors purchase the stock?
What is the time horizon of the investment?
What is the expected rate of return?
After one year the stock has underperformed or over performed?
Do you plan on buying, selling or holding your position?
How risky is this stock within your overall portfolio?
Mutual Fund Investment - the following comprehensive 4-step procedure should be followed to choose a mutual fund…
Limit your investments to low-cost, no-load mutual funds.
Seek out investment vehicles with a solid track record spanning 5-10 years.
Assist your investments with a seasoned portfolio manager who adheres to a sound investing philosophy.
Recognize the unique risks connected to each mutual fund.
Finding success in investments relies on recognizing your investor profile and implementing a dependable investment strategy. Utilizing behavioural cues can aid investors in avoiding mistakes, and ultimately having a sound financial base for future investments. In all, simply put, behavioural cues from the market should always be used alongside quantitative analysis of the market for safe security trading.
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