Behavioural Finance is where anthropology intersects Economics, and Psychology intersects Finance. While the well read economic theory tells that markets are efficient and investors are rational, studies on Behavioral Finance indicate that markets are inefficient and investors do not behave rationally. There is a lot of difference between how one makes decisions and how one should be making them. Nobel Prize winning Prospect Theory given by Daniel Kahneman on which Behavioral Finance basics lies also dwells upon the investing behaviors of players in the market. There is no ideal decision in case of investing – it all depends on the sentiments prevailing at that point in time. Booms have always been followed by the busts because of the contrary behavior from set of peoples.
Various investor behaviors such as loss aversion, sunk cost fallacy, mental accounting, mental heuristics, decision paralysis, endowment effect etc. makes them behave irrationally. Loss aversion is a fallacy when people fear to lose their money. When people face sure profit situation, they tend to get conservative and when they face loss they take more risks; interestingly rather being risk averse, investors are loss averse. Loss aversion is the reason why people get out of the market early when making profits and losers stay and pile up as they hold on to losers and short winners.
While loss aversion leads to people putting their good money after bad, it’s when people attach themselves so much to their past actions that they don’t realize that past cost that has already been paid and cannot be recovered. This is Sunk Cost Fallacy. It can be described well with example of people ordering too much in a restaurant and then eating because they have already bought lot of food without realizing the after effects. People increase their commitments to justify their past actions just because of ego associated with. As they say, to forget the past and move on is easier said than done.
Making a decision to not make a decision is also a decision. Not making a decision let us lose 50% chance of getting right. In case of multiple opportunities, people delay decisions or even don’t make one. Decision paralysis is when people can’t make decision at particular point in time. During the IT bust, the market did not slip down in one go. The drop was gradual before the final steep downward slope. Investors don’t sell at the Bull phase of the market and once the market falls, they tend to wait for years to sell at a profit.
When somebody gives us something, we would like to pay less than what we would like to be paid for the same thing which belongs to us. This is endowment effect. The thing which belongs to us becomes more valuable just because we own them, than things owned by others. It makes valuation of things difficult and discards opportunity costs. When the stock prices move up, investors increases their limit as they are supercilious of their holdings and think that market is undervaluing it and their stock still has a long way to go. Endowment effect is used by marketers by giving products on trial with money back guarantee, but once people use it for some time it is difficult for them to part away from it.
Richard Thaler, pioneer of Mental Accounting explains it as a most common and costly miscalculation made by investors. People tend to keep money into different brackets depending upon how it is acquired and the intensity of effort associated with it. People earning 1000 rupees after working for a day and winning 1000 rupees in a lottery treat them differently despite both the amounts having same purchasing power. People tend to differentiate between large purchase and small purchase, quantity of money in contention, earned income and gifted income, cash and credit card purchase. People hold on to losers as they think they lose only when they sell. Paying cash matters more than paying through plastic as we can visually see that money.
When brain makes decisions through shortcuts without accessing, processing and analyzing the information properly leading to biases, the phenomenon is called Mental Heuristics. Investors make many decisions based on trial and error without assessing the probabilities associated with it. The NDA was sure they were winning 2004 general elections but post-election analysis revealed that their India Shining campaign was majorly sold in tier 1 cities hence, losing out on more than 60% of India that lives in rural areas.
Also, did we ever notice that we tend to pay more just because people around us are willing to pay more without proper analysis of the worth of the purchase. Dotcom bubble was one of the results of Herd Mentality.
There are various other investor behaviors such as overconfidence and anchoring. Successful investors think they are successful because of just their own abilities and fail to realize stock market performance. Rising market lifts the egos of Investors. Anchoring is when people fail to see reality and are anchored to purchase price. Inflation erodes purchasing power of money, so investing becomes important but understanding behaviors help in getting positive real after tax return. To become savvy investor, one needs to understand difference between speculating and investing
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