Investor psychology

Khozema Dhanerawala explains the role of human emotion in influencing investment decisions.

Behavioral finance attempts to understand and explain how human emotions influence investors in their decision-making process.

Economic theory is based on the belief that all investors behave in a rational manner. This means behaving in a logically manner backed by facts and data.  But researchers have found out that investors don’t always behave in a rational manner. Here we try and explain to you how human emotions influence decision making process.

Psychologists have documented many patterns regarding how people behave. Some of the patterns are as follows.

• Rules of thumb: Rule of thumb makes investment decision making easy. But, they sometimes create biases which can lead to sub-optimal investment decision.
  For example, there is a thumb rule that investor in group age of 20-30 years should have greater exposure to equity assets. Risk exposure should not be based only on the age of the investor. There are other factors like risk appetite, time horizon, expected return also to be looked at.
• Overconfidence: Overconfidence means over optimistic assessment of one’s ability. In a 2006 study entitled "Behaving Badly", researcher James Montier found that 74% of the 300 professional fund managers surveyed believed that they had delivered above-average job performance. In the American context, research shows it is not possible for such a large percentage of fund managers to outperform the index.
  
  For example an investor with experience in the FMCG sector will over weight his investments in FMCG stocks in the belief that he has the ability to track the sector. Being confident of one’s ability is not an anomaly but overconfidence on your ability to understand FMCG sector and not diversifying adequately is an irrational behavior.
• Anchoring: The concept of anchoring draws on the tendency to attach or "anchor" our thoughts to a reference point - even though it may have no logical relevance to the decision at hand.
  
  For example, some investors invest in the stocks of companies that have fallen considerably in a very short amount of time. In this case, the investor is anchoring on a recent "high" that the stock has achieved and consequently believes that the drop in price provides an opportunity to buy the stock at a discount. A mere fall in price does not make such stocks investment worthy. In fact, it may be a signal for a secular decline in the long term prospects of the business.
• Mental accounting: Mental accounting refers to the tendency for people to separate their money into separate accounts based on a variety of subjective criteria, like the source of the money and intent for each account.
  
  This is how mental accounting works: let’s say you have bought Rs.150 ticket to a movie. When you show up at the door and realize you have lost your ticket, do you buy another? Probably you may not.
  
  But let’s say you hadn’t bought the ticket yet, and you show up at the door of the movie hall to buy your ticket. Unfortunately, you realized you’ve lost Rs.150 in cash since you walked from your car. Luckily, you still have enough in your wallet though to cover the cost of the ticket. Do you buy the ticket? Yes.
  
  Why?
  
  Both scenarios are a loss of Rs.150. However, in the second scenario you separate the loss of the Rs.150 from the purchase cost of the ticket. In the first you consider the cost of the event as a total of Rs.300 and retch at the high cost. (Source: Why Smart People Make Big Money Mistakes- Gary Belsky)
• Confirmation Bias: The confirmation bias suggests that an investor would be more likely to look for information that supports his or her original idea about an investment and ignores any information that contradicts his belief. As a result, this bias can often result in faulty decision making.
  
  For example, while analyzing a particular stock, one may look only for good information about the company and ignore the bad information affecting the stock.
• Herd Behavior: Is the tendency for individuals to mimic the action of a large group giving more weight age to the opinions and actions of other people than their own.
  
  For example, during the dotcom boom many investors had invested in internet-related companies merely because others were doing so. Even though many of these dotcoms had no revenue model, investors felt reassured about these companies as many others were investing, leading to increased demand for internet stocks and their prices forming a bubble.
  
  This irrational but entirely human behavior makes many distortions in the market, giving experienced and disciplined investors a great advantage to profit from such opportunities.
  
  What should be your counsel to your clients?

1. Stay calm and exercise self-discipline in situations of rapid change and stress.
2. Invest regularly.
3. Stick to your plan.
4. Be guided by your own goals.
5. ‘Impulse’ investing can be dangerous. Stay away from tips and heresay.

The rational antidote to irrational behavior is to stick to a routine of regular, disciplined investing!