The recent deep cut on the bourses has left many investors wondering what they should do next. Should they cut losses or should they buy now? Amidst all the news and views, an understanding of behavioural finance could hopefully help.
Behavioural finance seeks to find how investor emotions and psychology affect investment decisions. Unlike conventional finance, which assumes that investors are ‘rational economic beings' basing their decisions on cold facts with little room for emotion, behavioural finance suggests that investors (being human beings after all), have their bouts of emotion-induced irrationality.
And it's got some sound data to back up the claim. After all, would rational markets allow the build-up (and bust) of humungous bubbles, from the Tulip mania of the 1600s to the more recent global financial market catastrophe? Albert Einstein sure knew what he was talking about when he said “Only two things are infinite, the universe and human stupidity, and I'm not sure about the former”.
In essence, behavioural finance throws light on the much-observed phenomena of investors getting swayed by emotions and making sub-optimal decisions. This, while causing them avoidable loss, also leads to market anomalies, which present money-making opportunities for the truly discerning investor. Listed below are some common irrational investment behaviours:
Herd Behaviour: This is exhibited by investors when they blindly follow the crowd, without a rational assessment of whether the path chosen is led by a Pied Piper. For various reasons including the fear of being left out of the action, wanting to conform, or simply believing more in the ability of others than in themselves, investors chose the beaten path. Herd behaviour provides the air with which market bubbles inflate. Eventually though, all good things come to an end, and bubbles too get pricked. Prompting both the wise and chastened to say, “See, I told you, the majority was indeed a collection of fools.”
Overconfidence: What at first seems to be an anti-thesis of herd behaviour, is actually taking belief in one's abilities too far – perhaps to the point of being wealth destructive. Clearly, humility is not among the many virtues of the overconfident investor who believes he has what it takes to beat the market each time, every time. However, many a time this has devastating consequences. Humility and practicality are necessary attributes which help adapt to the writing on the wall, in ever evolving market situations.
Anchoring: Faced with the unknown, investors will cling on (anchor) to anything, even if totally irrelevant, to justify their decision. For instance, a stock's low relative price-to-earnings multiple, compared with peers and its own historical data, could be cited to hold on to a position, not taking into account that the low multiple may be justified given the company's deteriorating fundamentals. The unwillingness to get off the high horse could be potentially be quite damaging to the investor, given that outcomes will be based on relevant factors at play.
Loss Aversion: How many times have you held on to losing stocks in the hope that “this too shall pass”, only to find that the cut just got deeper? Studies (the prospect theory) have shown that the pain of loss is more than twice the pleasure of gain. So, while most investors will tend to realise gains, losses tend to remain book entries and unrealised in the hope of being recouped. Several investors also resort to “averaging” at lower prices, thus increasing manifold their exposure. Now, if an objective assessment reveals that the price decline is indeed unjustifiable and that the company's future prospects translate into a high potential price, holding on or averaging may make sense. Else, it's best to cut losses before burgeoning losses cut you.
Overreaction: Disproportionate reaction to news, both good and bad, has been oft-seen in the financial markets. The hammering of many healthy banking stocks after the recent ‘bribe-for-bank loan scam' was a typical case of market over-reaction. Poised investors should desist from being swept away by tides of irrational optimism and unjustified pessimism, given that the overreaction effect tends to wear off with time. If anything, such overreactions may provide good opportunities to realise profits or go in for good “value-buys”.
Mental Accounting: Some investors tend to classify wealth into silos, depending on their source and intended use. For instance, an investor may have deep emotional attachment to inherited shares, and may be reluctant to sell them, despite being in need of money and the price being attractive. Such mental accounting of money, however, is not quite logical, given that money is perfectly fungible. After all, “money is what money does”.
In addition to the above, investors also exhibit other behaviours including representativeness (judging based on stereotypes), home bias (tilting towards the comfort of the familiar), and recency bias (basing decisions on recent happenings).
While it's easier said than done (given that it requires emotions to be kept in check) investors would do well to avoid the pitfalls arising from common investment behaviours. This applies irrespective of whether markets are calm or choppy.