The study of behavioural finance has brought
a new wave of transformation in the finance industry.
Investors
usually are hasty when it comes to investing their funds. They tend to react
per the information shared with them and the amount they have to invest. A lot
of factors should be considered before investing anywhere. This blog helps to
understand the behaviour of investors and what leads them to lock an
investment.
Many economic
theories are based on the notion that individuals behave rationally and every
existing information is set in the investment process. An efficient market
hypothesis is the crux of this assumption theory.
However, several
researchers have nullified this assumption of rational behaviour.
Behavioural
finance aims to study the way human emotions affect investors in their
decision-making process.
Behavioural Science
Many investors
believe that traditional or behavioural theories of finance affect investment
decisions. Those who apply the traditional finance school of thought while
investing should determine the basic value and the securities they want to
invest in. In case the securities of interest are overvalued or
undervalued, the determination of the fundamental value is geared towards
establishing investments.
To follow this
process, it requires valuation techniques and formulas. Whereas it is also
suggested by behavioural finance that investors use their psychological
knowledge in making investment decisions. It requires the application of
various rules of thumbs while making any kind of investment decision.
According to the
theory of risk and return on investment decisions, the more the risk of
investment, the more are the returns, considering the level of accepted risk.
Some strategies that an investor can adapt to stay ahead in the game are
applying industry best practices, rational risk management, and proper portfolio
construction and management.
The experts of
behavioural finance ideology state that the decisions on investments are based
on factors such as endowment, regret aversion, loss aversion, mental
accounting, herding behaviour and cognitive factors including overconfidence,
gambler's fallacy, and hindsight biases.
Investment Decisions
Individual
investors are different from institutional investors in terms of their
investment horizons, investment profiles, and the amount of money disbursed on
an investment venture. An individual investor acts on his own will, as a
private entity, while institutional investors are usually companies. They
include entities such as hedge funds, insurance companies, commercial banks,
mutual funds, and endowment funds.
Investment
choices involve the resolution of which security or asset to invest in, how
much to invest, when to invest, and the investment period. Different investment
alternatives differ in their risk and return profiles—the risk appetite of an
investor determines different alternative investment and whether to invest
their money in either shares, bonds, marketplaces, securities, or other
securities traded at NSE.
Dalbar, a
financial-services research firm in 2001 released their study titled
"Quantitative Analysis of Investor Behaviour," which concluded that
most investors fail to achieve market-index returns. Let us tap into the
reasons why this is happening and how behaviour affects the investment.
Regret Theory
When a person
realises they have made a mistake in judgement, he/she deals with the emotional
reaction of experiencing a fear of regret. This emotional reaction is called
Regret theory. Investors become emotionally affected by the price at which they
purchase the stock and have to overcome the idea of selling a stock.
Regret theory is
applied in the case when an investor discovers that a stock which was
considered by them to purchase has increased in value. Some investors go with
the public and purchase the stocks which are being bought by everyone else justifying
their decision with "everyone else is doing it."
What is peculiar
is that most of the investors feel less embarrassed about losing their money to
a popular stock that half the world holds than about losing their money on an
unknown or unpopular stock.
Mental Accounting
Humans have an
inclination to place certain events into mental compartments because human
behaviour is impacted by more than just the events.
Assume an
instance where one aims to catch a show at the local cinemas and tickets are Rs
500 each. When you get there, you realise you've lost a Rs 500 bill. But you
still buy a Rs 500 ticket for the show anyway? As per behavioural science, it
is found out that nearly 80% of people who go through this situation would buy
another ticket.
Let us assume
that someone has paid Rs 500 for a ticket in advance. On arriving home, the
person finds out that the ticket is at home. Now, will the person pay Rs 500 to
purchase another ticket? As per behavioural science, only 40 % of the investors
would purchase another ticket.
It is intriguing
to observe that the same amount of money is lost in both situations but
different mental compartments are shared.
The best
explanation of mental accounting is the delay in selling an investment that once
observed huge gains and now is experiencing average gains. When the market is
experiencing a bullish trend, the economy is booming, hence investors get
accustomed to healthy returns. While deflation, the net worth of investors
reduces making them more hesitant to sell at a smaller profit margin. These
investors cause mental accounting to create mental compartments for the gains
they once had.
Prospect/Loss-Aversion Theory
It is evident
that people prefer investment returns to uncertain ones where people want to
get paid for taking extra risk. Prospect theory is when people show a different
angle of their emotions towards gains than towards losses. People fail to enjoy
gains and instead are more stressed by proposed losses.
When a client's
portfolio experiences a gain of Rs 5,00,000, no investor advisor will get
swamped with calls. However, if a client incurs a loss of Rs 5,00,000, the
phone won't stop ringing for the advisor, hence concluding that a loss will
always be given more importance than a gain of the same amount.
Another reason
is put forward by the loss-aversion theory for investors to choose to hold
their losses and sell what they have won. Investors believe that those who have
lost today can turn out to be potential investors tomorrow. Most investors make
the mistake of following the herd and invest in stocks or funds which are
popular amongst other investors. Various researches point out that money flows
into high-performance mutual funds or alternative investments like invoice discounting
faster than money flowing out from underperforming funds.
Anchoring
It has happened
that the absence of substantial information has led investors to believe that
the market price is the correct price. Due to this a lot of faith is put by the
investors in the recent market views, opinions and events, and mistakenly
extrapolate current trends which are different from historical, long-term
averages and expectations.
During the
bullish trend of the market, the decisions of investments are usually
determined by price anchors, which are the prices considered essential because
of their closeness to recent prices. This makes the returns of the past trivial
in investors' decisions.
Over-/Under-Reacting
When the market
experiences a boom, investors experience optimism assuming an upward trend in
the market to follow. However, investors become very negative during downturns.
Over or under reaction to market events is when an investor anchors, or places
too much emphasis on recent events while sidelining historical data leading to
prices falling too much on bad news and rising too much on good news.
Overconfidence
The general
trend is for people to rank themselves higher than their average abilities.
Furthermore, they also exceed the accuracy of their knowledge and their
knowledge relative to others.
Although many
investors share the belief that can consistently time the market, there is a
vast amount of evidence that proves otherwise — overconfidence results in
excess businesses, where trading costs can sink profits.
Conclusion
Behavioural
finance inevitably reveals some of the characteristics rooted in the investment
system. Behaviourists will dispute that investors frequently behave
irrationally, producing mispriced securities and inefficient markets not
forgetting the opportunities to make money.
It can be true
for some instances but continuously tapping these inabilities is a challenge.
The question remains whether these behavioural finance theories can be used to
handle money economically and effectively.
That said, at
times investors can turn out to be their own enemies. Investors are always
trying to figure out whether the market will pay over the long term which often
results in unusual, unreasonable behaviour, not to mention a dent in your
wealth.
Implementing and
following a strategy which is well thought out can help investors avoid many of
these common investing mistakes.
No comments:
Post a Comment