Our day-to-day conversations may often have us hear, “Oh, but that is how he was likely to react,” or something like, “that is typical human nature.”
What this statement refers to is the innate ability of human beings to act in a certain way in a given situation. Such reactions or responses are generally not taught but often emerge instinctively. These could be related to what makes us happy or angry or how we tend to behave through certain phases of life, etc.
Similar to how one goes about life, the journey of investing for an individual also has some common behavioral patterns. The two basic emotions related to investing are greed and fear - and these often directly or indirectly tend to drive decisions related to investing.
Let us understand a few behavioural patterns or traits which investors tend to follow in their journey of investments:
Loss Aversion: This behavioural trait refers to how investors are much more impacted by, or are sensitive to, losses compared to gains. For instance, the loss of Rs 10,000 will upset an investor much more than the happiness they will feel on gains of an equivalent amount. Some studies state that the psychological impact of a loss is as much as double that of a gain. This trait often leads to investors being conservative when choosing asset classes, skewing towards those which have limited risk, even though it means that returns are also likely to be limited.
Herd Behaviour: This tendency refers to how an individual is likely to follow or believe in what masses are doing or saying. If eight out of ten investors opine that the stock market is overvalued and that one should be selling at the current levels, then an investor following herd behaviour will do the same, without checking whether fundamentals also show expensive valuations. Herd behaviour also happens because of a fear of what is known as ‘missing the bus’. This means that an investor feels that not following the trend could lead to losses.
Mental Accounting: Instead of treating all their funds in a wholesome manner, investors tend to compartmentalize their funds according to various requirements. For example, a certain amount of funds earmarked for a specific goal may be earning 3% in a savings account, while on the other hand, you are paying off interest in double digits for a loan you have taken. While this strategy can help ring-fence goal-specific savings from adverse market fluctuations or inadvertent spending, it is ultimately not beneficial for investors because they are not making the optimum usage of their funds. A simple thumb rule for any debt taken is that the highest interest debt should be paid off first, and the tendency of mental accounting contradicts this guideline.
Recency Bias: Similar to an availability bias, an investor will typically refer to the most recent outcome or event, or one that can be easily remembered for the sake of convenience. This means that if you have seen positive returns on your investments for two years in a row, you will tend to blur out the negative performance prior to these years, simply because you want to remain invested and believe that the recent positive performance is set to continue. A popular saying in the capital markets is that ‘this time it's different,’ underscoring how investors want to believe that previous patterns followed by markets, especially in case of corrections, may not happen this time around.
Anchoring: This trait sees an investor using their experiences as a benchmark for all assessments. What this means is that if an investor has made a 10% return on their portfolio over a year, they will judge the performance of someone else’s portfolio based on this 10% that they have made, irrespective of what a benchmark may have earned in the same period. The drawback with this is that your reference point could vary significantly from the trend in the broader market, which makes the analysis skewed and inaccurate.
Confirmation Bias: This can also be understood as a form of seeking validation, where an investor will look for answers in a manner which reaffirms their view on a particular asset class or security. If investor A believes that shares of company XYZ must be bought at current levels, while investor B believes that they are expensive, investor A will try and point out all reasons why they think that the shares of company XYZ can be bought, focusing only on the company’s positives. In such instances, an investor may also tend to ignore negatives about the concerned security or asset class, making it an incomplete view.
An understanding and awareness of these concepts of behavioural finance can be helpful for investors as it helps them from falling prey to emotional decisions, which can ultimately lead to losses or restrict gains.
