Behavioural Finance – How Human Behavioural Biases Affect Investment Decisions (I)
17th May, 2013
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Human beings are rational and intellectual creatures. We try to act in the most rational manner in a given circumstance, including when it comes to taking investment decisions, yet we clearly know that emotions do affect such decisions. People in the world of investments commonly talk about the role greed and fear play in driving stock markets. As the legendary investor, Warren Buffet says, “Be fearful when others are greedy, and be greedy when others are fearful.” This is so true that even a 6 year old kid would vouch for it, yet when it comes to investing, most investors do the reverse. Even the world’s greatest scientist, Sir Issac Newton, could not escape the gravity of the rise and fall of the South Sea stock which ultimately resulted in a bubble. He ended up losing twenty thousand pounds. When Sir Isaac Newton was asked about the continuance of the rising of South Sea stock, he answered, “I can calculate the movement of the stars, but not the madness of men.”
Another instance of unexplainable human behaviour emanates from the following example – We clearly know that the loss from losing Rs.1,000 in an investment should be the same as pleasure from gaining Rs.1,000. But in reality, this is not the case. The loss is many times more than the pleasure because by nature most of us are risk averse and don’t want to see red ink in our portfolios. And this is where understanding of human behaviour comes into play.
Behavioural finance is commonly defined as the application of psychology to understand human behaviour in finance or investing. It is a field of finance that proposes psychology-based theories to explain stock market anomalies. Within behavioural finance, it is assumed that the information structure and the characteristics of market participants systematically influence an individual’s investment decisions as well as market outcomes.
Here we have listed out a few biases which most individuals possess and are affected by when investing:
Overconfidence: Psychology has found that people tend to have unjustified confidence in their abilities and decisions. Most of us think that we are above average in life and rate ourselves much higher than any objective measure would. For example, researchers found that most people rate themselves in the top third of the population in terms of driving ability. This can’t be true because, by definition, 50% of drivers are below average. This can affect people from all walks of life such as CEOs, doctors, lawyers, students and investors also. All these groups tend to overrate the accuracy of their own ability to predict the future.
Overconfidence can cause a real problem for investors in the following ways:
An adviser can help you overcome mistakes resulting from overconfidence and give you an objective perspective on your investment decisions.
In the next part of this article, we shall look into loss-averse behaviours and how they can limit an investor’s success.
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