Introduction
Take stock market to be as a person with mood swings. It can go from being irritated to being ecstatic, “it can overreact hastily one day and make amends the next” (Mclure Ben, 2021, March20, p.1). Behavioural finance states that financial decisions are based on human emotions, biases and that humans are not as nearly rational as defined by the traditional financial theory.
Behavioural finance is surely insightful in analysing market returns in reminiscence but has been unsuccessful in helping the investor to develop a strategy to get higher returns in future.
Difference between behavioural finance & traditional finance
Traditional finance theory assumes that people are ‘rational’, which means that they are utility maximisers and are free from the effects of social relations or emotions. Additionally, it is also posed that the firms are profit maximising organisations and the markets are efficient in their working.
Although the notion of traditional financial theory seems simple to understand but, the above-stated assumptions don’t hold true. In fact, according to Lin Melissa, “80% of individual investors and 30% of institutional investors are more inertial than logical” (p.1). These deviations from theoretical predictions have helped to build the framework for behavioural finance. Analytical and emotional aspects of investing like psychology, sociology, and even biology is focused upon under behavioural finance.
How practical is the theory of behavioural finance?
The effect of behavioural finance research stays greater in academia than in realistic money control. It is not possible to tell when will the market hit the top or when it would be at the bottom, but with the help of behavioural finance, one can describe what a watershed would look like.
In a nutshell, we can say that behavioural finance is the study of how psychological factors dominate investor’s behaviour in the market by focussing on the fact that people are not always rational, and their own biases impact them.
The herd instinct
When people follow the same actions as that of others in the belief that others have already done their research, the phenomenon is called the ‘herd instinct.’ In the financial sector, investors, rather than relying on their own analysis, start making similar investments as other investors. This particular action, as per behavioural finance theory, can be a human tendency of not being alone or being swayed by what society does and believing that the majority must be right.
To avoid the herd instinct, one must do the following-
· Be thorough in their research and take diligent steps towards it
· Take their own decisions
· Don’t be afraid to stand alone, if you feel your instinct is right
Losses v/s gains: Which is more significant?
Let us give a choice to someone of a sure Rs500 or, on the flip of a coin, the possibility of winning Rs1000 or winning nothing at all. There is a huge chance that the person will go for the sure offer of Rs500, even though it is less than Rs1000 which he can potentially win.
On the other hand, if we offer a person a choice between- a sure loss of Rs500 or on a flip of a coin, either a loss of Rs1000 or nothing. The person, rather than accepting a loss of Rs500, will probably go for the second option. That's because people tend to view the possibility of recovering from a loss as more important than the possibility of greater gain. This is called ‘loss aversion.’
In 1992, Amos Tversky and Daniel Kahneman while further developing the original theory of loss aversion (which was formulated in 1979) proposed that losses are weighed twice as heavily as potential gains by the people. The same possibility holds true for investors as well, regardless of how low the price drops, investors often hold stocks rather than bearing loss, believing that the price will eventually come back.
Decision-making errors and biases
Both cognitive, as well as emotional biases, come under investing behavioural biases. Cognitive biases originate from memory, statistical or information processing errors. On the other hand, intuition or impulse is the root of emotional biases, which result in decision making based on feelings rather than facts.
Following are the various errors that are imbedded in behavioural investing-
1. Self-Deception
It is the false belief that we know better than we do, which results in failure to make an informed decision.
2. Heuristic Simplification
Information processing errors can be termed as ‘Heuristic simplification’.
3. Emotion
When our current emotional state influences any financial decision that we take, it is the emotional error in behavioural finance. This may lead to our decisions being irrational and too related to personal feelings.
4. Social Influence
Social influence considers how our decisions are altered as per others.
After discussing behavioural errors, let us have a look at various human biases-
1. Overconfidence and illusion of control
When the investors believe that their control over their investment is more than what truly is, these investors may overrate their abilities to identify successful investments. Moreover, overconfidence has been labelled as the paramount reason behind the investors’ vulnerability to financial fraud.
2. Mental accounting
It is human tendency to categorise each expense or investment in mind, for example, ‘retirement’, ‘education’ etc. Different categories often carry a different level of risk tolerance. A study suggests that this concept of mental accounting often results in violation of traditional economic principles by people. In a nutshell, we say that investors usually keep their focus more on individual categories, rather than taking their overall wealth position into account.
3. Familiarity bias
It is often seen that investors prefer to invest in ‘familiar’ investments of their culture, country, or company, despite the obvious gains from diversification.
Apart from geographical familiarity bias, there is a strong will that can be seen from investors side to invest in their employer’s stock. This can be dangerous for employees because if they invest a large chunk of their portfolios in their own company’s shares, they will aggravate losses if the company performs poorly.
4. Anchoring
The decisions of people are often based on the first source of information they get and they then use it as a subjective reference point for any future decisions. We call this phenomenon ‘anchoring’. Anchoring can be seen in different sectors, but as far as investing goes, a stock’s purchase price or market index levels can often be anchored by investors.
5. Representativeness bias
An investment is classified as good or bad based on its recent performance under representative bias. This leads to investors buying more stocks after the prices have risen (expecting continuous growth) and when the prices are below the original value, these stocks are often ignored. “People tend to think in terms of past experiences, arriving at results too quickly and with imprecise information” (Lin Melissa, p.4).
6. Attention bias
In a study conducted in 2006, many behaviouralists came to a result that individual investors are more likely to buy rather than sell the stocks that catch their attention (stocks in news or stocks with high one day returns).
The simple reason behind this is that before making an investment purchase, investors need to sieve through thousands of stocks, but the amount of information they can process restricts them. However, the same is not the case while selling a stock since they only must sell the stocks already owned by them. Nonetheless, attention-based investing doesn’t guarantee positive results.
Overcoming behavioural finance issues
“Investing success doesn’t correlate with IQ after you’re above a score of 25. Once you have ordinary intelligence, then what you need is the temperament to control urges that get others into trouble”- Warren Buffett
Systems like employing feedbacks, auditing trails for decisions and checklists can help us alleviate the effects of behavioural biases we are born with and help us make more rational decisions. Other ways of reducing the negative impacts of behavioural biases include focusing on decision-making process and not the result. This will lead to better and reflexive decision making. Lastly, we should invest by preparing, planning, and making sure we pre-commit.
Though behavioural finance is controversial in the present time, the importance of the same will be realised eventually and one day its ideas will become conventional, as predicted by Professor Richard Thaler in “The End of Behavioral Finance,”
References:
1. Lin, Melissa. Why Investors Are Irrational, According to Behavioural Finance. Toptal Enterprise. https://www.toptal.com/finance/financial-analysts/investor-psychology-behavioral-biases
2. What is Behavioural Finance? Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/behavioral-finance/
3. Mcclure, Ben. (2021, March 20). An Introduction to Behavioural Finance. Investopedia. https://www.investopedia.com/articles/02/112502.asp
4. Chen James. (2021, July 24). What is the Prospect Theory? Investopedia. https://www.investopedia.com/terms/p/prospecttheory.asp
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