Traditional finance has always presumed that investors are rational in their decision-making process with respect to the stock market, risk appetite and maximum utility. However, behavioural finance studies that human beings are not as logical and pragmatic as economists once believed them. Their investment decisions are influenced by a number of factors such as anchoring, risk propensity, gambler's fallacy, overconfidence and herding behaviour.
Behavioural finance hence is an area of study which focuses on economics & psychology and how it’s used to analyze the various investment decisions as well.
Anchoring is a cognitive bias in which a person's decisions are affected by a certain reference point or “anchor”, even though it may not have any relevance in terms of statistical information. For instance, while choosing a share investors often look at the 52-week period to assess and analyze the trends in the market. This initial figure, hence, sets as the anchor in their mind. Now, the highest price paid for the security can be a misleading anchor as it may make the current price look cheap even when the security is overvalued. An investor may also fixate on the price paid for an asset and refuse to sell it despite the bad performance, hoping to at least break even rather than lose money without thoroughly examining the causes behind its depreciation. Therefore, these past experiences or overvaluation of securities might be a bias making it harder to make the right investment decisions.
Risk propensity or risk appetite basically refers to an individual’s ability and intensity of taking risks. It’s generally higher during periods of economic growth and lowers during recession. This might derail an investor’s decision which results in heavy losses in the long run.
Gambler’s fallacy refers to the situation in which an individual believes that an outcome that has occurred many times in the previous attempts will have fewer chances of occurring again and vice versa. Thus, they may continue to invest or gamble and lose. The most prominent type of inverse gambling fallacy in investing is the tendency of chasing performance, wherein investors look at last year's best-performing funds and invest in them, expecting that the series will continue and they will be the best-performing funds again the following year.
Overconfidence, as the name suggests, people tend to be overconfident in their decisions and may overestimate their ability to know what will happen, not paying heed to the existent information and carrying on with their gut feeling.
Herding has the most significant impact on any investor’s decisions. It occurs when investors follow the herd or the crowd instead of their own analysis. The late 1990s and early 2000s dot-com boom is a classic example of herd instinct's role in the growth and eventual bursting of that industry's bubble. The dot-com bubble or the Internet bubble was a stock market bubble caused by excessive speculation of Internet-related companies in the late 1990s (like- Pets.com or communication companies like amazon ). They lost a large part of their market capitalization as high as even 80%.
Therefore, herd instinct at scale can create asset bubbles or market crashes via panic buying and panic selling.
This suggests that the psychological factors have a direct impact on the risk appetite and decisions of the investor. An investor being really overconfident will make them more risk seekers while investors who are low on confidence will definitely be prone to risk-averse, followed by other biases. Thus, using technical analysis will help in making better investment decisions using charts and graphs which study the market trends. They can be used to identify certain patterns which may further be used for future predictions. For instance, Dow theory was given by Charles Dow (one of the founders of Wall Street Journal), which is a form of technical analysis that studies uptrends and downtrends. So higher bottoms refer to uptrends while lower peaks mean downtrend. According to it, as long as a particular stock is displaying higher bottoms investors should retain it but as soon as it starts showing lower peaks investors should immediately sell out to ensure maximum profits and vice versa.
To sum it all up, it's important to study the relationship between finance and other psychological factors which will further help in making sound decisions as human behaviour is very volatile and changes from time to time. Hence, to maximize profits and make effective decisions it's essential to be free from any biases and errors.
References:
1. E. (2021a, February 21). The Gambler’s Fallacy: odds are not in your favor. Econowmics. http://econowmics.com/the-gamblers-fallacy-odds-are-not-in-your-favor/
2. Gupta, A. (n.d.). Psychological Factors Affecting Investors Decision Making. Journal of Xi’an University of Architecture & Technology. https://www.xajzkjdx.cn/gallery/15-april2020.pdf
Comments