4 min read.Updated: 08 Oct 2021, 12:33 AM ISTAnagh Pal
Human psychology plays an important role when it comes to investment decisions, say experts
Let us start with two conflicting economic principles. The first is the theory of rational behaviour, which assumes that people take decisions that are likely to benefit them rather than those that are neutral or cause them harm. According to this theory, human beings have control over themselves and are not swayed by emotions.
On the other hand, there is behavioural finance, which falls under behavioural economics. Behavioural economics says that people are emotional and get distracted easily and do not behave rationally. Behavioural finance suggests that rather than being rational, people often make financial decisions based on emotions and psychological biases. And this is true of investors as well.
Terrance Odean, Rudd Family Foundation Professor of Finance, Haas School of Business, University of California, Berkeley, and a noted expert in behavioural finance, explains how this new school of thought came into being.
During the 1970s and ’80s, most academic finance papers assumed that most investors were extremely rational in their investing decisions. Those who were not hyper-rational were assumed to behave unpredictably and independently from each other. Thus, only rational investors affected market prices. During the same period, psychologists such as Daniel Kahneman and Amos Tversky were studying how people actually make decisions. They found few, if any, people are consistently rational as rationality was defined by economists. Starting in the late ’80s, the work of these psychologists began to influence the thinking of economists. This led to the fields of behavioural economics and behavioural finance. In 2002, Kahneman won the Nobel Prize in Economics.
Odean, a student of Kahneman’s as an undergraduate, believes in the school of thought that investors behave as predicted by psychologists rather than as assumed by economists.
“I have found that overconfidence, limited attention, recency bias, loss aversion and excitement affect the behaviour of investors, particularly individual investors," he said.
Agreed Hersh Shefrin, L. Belotti professor of Finance, Leavey School of Business, Santa Clara University, and a Canadian economist best known for his pioneering work in behavioural finance. “Because investing is complex and humans are imperfect, the act of investing involves susceptibility to errors in both judgement and decisions," he said.
Hence, human psychology plays an important part when it comes to investing, said Chenthil Iyer, founder and chief strategist, Horus Financial Consultants and a Sebi-registered investment adviser. “Humans have an intuitive tendency to arrive at quick or short cut solutions for a complex issue and in this process make a lot of errors in judgement," he said. Let us look at some of the most common investor biases.
Recency bias: “Recency bias is the tendency to overestimate the probability that the future will be like the recent past," said Odean. This leads investors to chase recent returns i.e., buy stocks and other assets that have recently performed well. Return chasing by large numbers of investors can drive prices up leading to lower future returns.
Limited attention bias: Limited attention leads investors to buy stocks that catch their attention, but has much less effect on selling. “In aggregate, this results in large number of individual investors being on the buy side of the market for attention-grabbing stocks, which creates temporary price pressure on those stocks. Often, investors lose money by buying such stocks after the price has already been driven up and before it drops back," said Odean.
Confirmation bias: We all have been prey to this. This bias makes us seek information that we already believe in and ignore any information that is not in line with our beliefs. A very simple example is that if you strongly believe in the fundamentals of a certain company and are invested in it, you may tend to ignore any news about the company that is negative and should have raised a red flag.
Loss aversion: Investors are normally so scared to make a loss that they focus more on how to avoid a loss rather than how to make a gain. For example, even when one has clearly made a wrong investment choice, one tends to continue with it, as exiting it would mean an immediate loss.
Hindsight bias: “Hindsight bias makes us think that whatever happened eventually was more predictable than it actually was," said Iyer. If you ask people about the 2008 financial crisis, they will tell you that all the signs of the crisis were very visible beforehand. However, that was not the case. Investors not only did not listen to those who warned them about the crisis, they even made fun of them.
How to avoid these biases: “Mitigating biases is difficult. Avoiding them altogether is impossible because humans are imperfect. But it’s possible to do better, and usually that means putting good habits in place to counter biases," said Shefrin.
Knowledge is the most effective tool to fight such biases. He suggested that an investor should begin by reading about them, speaking about them with friends, trying and analysing other investors’ behaviour, and then meditate on one’s own behaviour.
The insights from behavioural finance will help investors to understand themselves better. “It will help them to be alert to situations where their emotional and psychological predispositions are becoming a hindrance to making optimal financial decisions, which include both spending and investment decisions," said Iyer.
As an investor, you should try and recognize if you are falling pretty to any of the common biases.
“However, my advice for most investors would be to buy and hold a well-diversified portfolio rather than trading speculatively. Low-cost mutual funds or ETFs are an easy way to invest in a diversified portfolio," said Odean.