Most traditional economic and financial theories begin with the basic assumption that individuals (investors) will act rationally in their decision making process. These theories undermine (if not blatantly ignore) the role of psychology in the way individuals interpret and act on their available options. Behavioral Finance practitioners worldwide have consistently highlighted, through formal research, why investors and markets behave the way they do.
One investor’s mistake can become another investor’s gain. At the same time, one investor’s mistake can also become another investor’s risk. It is hence important to understand the emotional reaction of a majority as well as oneself to better understand or take advantage of market behavior. Take an example of the reality shows currently very popular on the entertainment channels. Say, there is a fascinating prize for guessing the winner of a particular dance competition who in turn will be selected on the basis of public voting. Even if you are an expert choreographer, you stand the risk that most people (less brilliant than yourself) may pick another participant (his/her popularity may cover some flaws). Although you are endowed with the skill to pick the right participant, you will win only if others recognize the same talent that you have so painstakingly spotted.
Though such deviations from rationality are diverse some of the deviations are systematic and discernible. Some commonly observable heuristic driven behavioral errors observed in the world of investing are:
Representativeness: Representativeness refers to the tendency of investors to make decisions based on stereotypes i.e. to see patterns where perhaps none exist. Representativeness also arises where investors tend to assume that recent events will continue into the future. In financial markets this can manifest itself when investors seek to buy ‘hot’ stocks and to avoid stocks which have performed poorly in the recent past although they would be available at an attractive valuation considering their longer term prospects.
Gamblers fallacy: Gamblers’ fallacy arises when people use the law of averages of a relatively small set of observations. They inappropriately predict that a trend will reverse based on a very limited data points. Assume you are flipping an imaginary coin. Note down the outcomes which according to you will be possible if you flip it about 20-50 times. Count the numbers of runs (number of consecutive heads and tails) you have anticipated. Then take an actual coin. Flip and note the runs for the same number of tosses. You will find that you under estimate the numbers of runs of heads or tails. This happens because, in your mind, the probability of heads and tails is 50-50, a ratio which is reached only in a much large number of outcomes.
Over confidence: Individuals generally overestimate their predictive skills. This leads them to miss out on opportunities as they believe that they can invest at the exact bottom or sell at the exact peak of the market. Studies have shown that another side effect of investor overconfidence is excessive trading.
Anchoring: You are at a shop and bargaining for an item that you liked. The shopkeeper starts with a price of Rs. 300 and you very sensibly take a cue from it and start at Rs. 150. After a long discussion you both agree at Rs. 225 for the piece (a price which is making you smile). Is it possible that the item was worth only Rs. 100 but the first quote from the shop keeper put a mental point for you to start from? Anchoring refers to getting fixed to a value scale. Investors often fix or get anchored to a value of a security by its 52 week high or its all-time high rather than its actual valuation.
Loss-aversion: The pain of making a loss of a certain magnitude is more than twice the happiness of a gain of the same magnitude. Investors are hence skeptical of booking a loss on a bad investment decision. Profits, however, are very easily booked. The wish to avoid regret may bias new investment decisions of investors as they may be less willing to invest new sums in investments or markets which have performed poorly in the recent past.
Finally, how do weeds get into your garden?
During bull market rallies, even risk-averse individuals get wooed into riskier stocks.
Some of the observations regarding deterioration of investment portfolio or conditions when investors take more risk:
Feeling of being left out: A person is happy drawing a salary of Rs. 1lac provided others are drawing Rs.90,000. But he is unhappy about earning Rs.1.1lac if others are drawing Rs.1.2lacs. If an investor has missed out on a rally for being conservative and the comparable others have made money, he will be attracted to come in at valuations that he would otherwise consider not favorable.
Trying to make up with ‘high beta stocks’: Investors try to catch up to a missed opportunity by taking a bigger risk either by investing in high beta stocks or, worse, leveraging through F&O market.
Quick money: Easy money induces higher risk taking. If short term trading bets are yielding results, investor may keep principles of long term investing in their attics and increase allocations to stocks ‘buzzing’ with some rumours for quick money. Mental accounting also plays a role in this case where an individual keeps the profit from these trades in a separate mental account than the long term investment portfolio. The colour of the money is alas the same.
“Its just a small part of the portfolio”: it is easy to allocate a small amount of money to a stock that is a very high risk bet. However during a good rally, the number of stocks that have sub-standard fundamentals continues to increase.
Weeds that come into your garden often continue to be in your garden longer than the flowers. Trades taken in for a short-term play continue to be longer-term members due to regret aversion and loss aversion.
The above behavioral aspects of decision-making are stated for more descriptive rather than prescriptive ends. It is important for an investor to first understand the biases that can affect sound investment decisions. These concepts continue to be enriched through empirical research worldwide by many behavioral practitioners. Some have even provided investors with funds that identify opportunities on the principles of behavioral finance.
Quantitative portfolio allocation methods provide some tools to avoid these biases in investment. However for a mutual fund investor Systematic Investment Plan (SIP) is a disciplined approach which cuts through greed and fear to a large extent.