When it comes to investing, we are often our own worst enemies. The greed and fear factor easily cloud our judgement; being too afraid to lose leads us to take prejudiced action; biases in how we interpret and process the information can lead to sub-optimal decisions.
Stock market is often perceived as a person: It has moods, it can be bad-tempered or exuberant, it can overreact one day and make amends the next day and so on. So the question is can psychology really help us understand the financial markets better? Can we improve our investment decisions and profits using the psychology of investing? The answer is yes. How? The idea is simple: Investors are not as rational as the standard economic theory assumes; they are not rational being, they are human beings. Frequently emotions prompt us to make decisions that may not be in our rational financial interest.
The psychology of investing is better understood through the emergence of a fascinating new field called behavioural finance. Behavioural finance pairs emotions with investments and shows how emotions and cognitive errors can cause disasters in our investment decisions.
In stock markets, behavioural finance can help explain situations such as why we hold on to stocks that are crashing or are ridiculously overvalued, jump in late and buy stocks that have peaked in a rally just before the price declines, take desperate risks and gamble wildly when our stocks descend.
Common mistakes
Overconfidence: Investors tend to be overconfident in their ability to make decisions in an uncertain world. We often set unrealistic investment goals. Most of us often find it difficult to distinguish between luck and skill. We often forget failures and, even if we don’t, we tend to focus primarily on the future, not the past. We generally remember failures very differently from successes. Successes are due to one’s own wisdom and ability, while failures were due to forces beyond one’s control. Thus, we believe that with a little better luck or fine-tuning, the outcome will be much better next time.
The tendency to remember our good decisions and forget the bad ones is commonplace. We also tend to believe that if our last decision or two was correct, then we possess special market-beating capabilities. This was particularly seen in the bull run we witnessed in 2007 and mid-January 2008. Almost everyone in the stock market had become an expert. Everyone’s stock recommendation was generating exorbitant returns.
Irrespective of the overvaluations, people thought that the Sensex will still zoom over 30,000 levels and their stocks will keep generating higher returns. But then, we all know what happened. Markets bombed in late January and tumbled further in the following months, correcting 25-30% from its all-time highs. Over confidence and greed navigated the investment decisions and rationality was lost in the process.
The comfort of crowd – herd mentality: To humans, a group offers safety. Let’s take an example from the internet bubble of 2000. “My stocks were simply not going anywhere. My friends were investing in the information technology stocks and making a lot of money. There was so much excitement about these stocks. I did not understand much about IT companies but I bought stocks of IT companies. But soon regretted it, as I lost 70% of portfolio value.”
This is where behavioural finance helps in as it says that when everyone is excited about the market, you should be extremely cautious. Share prices are not just based on economic values but also on psychological factors that influence the market sentiments. Share prices are often far too volatile to be explained by fluctuations in economic factors such as dividends or earnings. Much of the volatility can be explained by fads and fashions that have a great impact on investor decisions.
I often advice investors to use their own analysis and judgement rather than following the crowd. Don’t invest in companies you don’t understand. From the earlier example, many investors may say of the internet bubble, “I had my doubts about the IT stocks, but everyone else seemed so sure they were winners.” This is what is usually seen in the stock markets ‘herding behaviour’. Most of the times, others influence our own investment decisions, against our better judgement. And this happens with the so-called experts of stock markets too.
In fact, studying Warren Buffett’s investing career, it has been said that his greatest advantage is not one of analysis, but rather his willingness to be anti-social.
Considerations
Behavioural finance is important and can help us in making smart investment decisions. But it would be a misconception to say that behavioural finance means people can beat the market. Behavioural finance doesn’t say, “There’s easy money, go after it”. It says that psychology causes market prices and fundamental values to part company for a long time. And although there’s a potential profit opportunity there, it comes packaged together with additional risk.
Finance offers no investment miracles, it can help investors train themselves how to be watchful of their behaviour and, in turn, avoid mistakes that will decrease their personal wealth. It provides a platform to learn from people’s mistakes, to modify and improve their overall investment strategies and actually profit from identifying these mistakes.
Even experienced investors are susceptible to making the judgement errors identified by behavioural finance research. The only solution to avoiding this error is discipline. Set realistic goals for portfolio’s long-term return.
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