Behavioural finance is a very interesting stream of economics that studies the irrationalities of human behavior when it comes to financial decision making. It also explains why most investors lose money in the financial markets and / or under-perform the market.
Behavioural Finance: A few basic tenets of irrationalities
If we earn USD100 from gambling or windfall gain, we are more likely to spend it for giving party to our friends. We tend to create different buckets in our mind (Hard earned money / windfall gain / inheritance etc) as to the source of money and it drives our end use. Money however has the same color and carries the same purchasing power irrespective of the source. An electronics store doesn’t question the source of money when the customer approaches to buy goods.
It also has an implication on our investing behaviour in Behavioural Finance. We are likely to be less conservative in our investments if in our mind the source of money is other than hard earned money. We are more likely to invest the money in risky assets and therefore probably lose it.
Various psychology tests have concluded that the pain from losing USD100 far outweighs the joy of earning the same sum of money. When we are earning a positive return on an investment, there is also a temptation to book profit lest we lose the money that we have earned. It explains why most of the scrips in the portfolio of an investor are loss making scrips (Read – poor investments) and therefore underperform the market.
When we are losing money on an investment, we tend to hold on to the scrip as we are averse to book losses. Scrips which are delivering profit are sold off and we are left with a less than an optimum portfolio.
There is an old saying that amateur investors book profits while professional investors book losses.
There is a tendency of retail investor to follow the latest trends and / or fancies of investment ideas. A very good example was during IT bubble of year 2000 when dot com companies were losing money / burning cash but were the darlings of the markets. Portfolios which would stick to time tested principles of picking companies with strong cash flow and low valuations were under-performing the market. Recession is invariably preceded by euphoria in financial markets and not surprisingly the world went into a tail spin with the collapse of IT Bubble in 2000. Similar euphoria in stock markets was visible in 2008 when the world was beginning to see signs of financial crisis
Parallels today can be drawn in the valuation of E Commerce companies like Amazon, Flipkart which keep burning cash but carry exorbitant valuations.
Herd behaviour in Behavioural Finance is what Warren Buffet cautions in his famous saying “investors should be greedy when markets are in a state of panic and panicky when markets are greedy”.
When we buy a book and find it to be not so interesting, we tend to complete it just because we paid for it. In the process we ignore, the cost of book is a sunk cost and the time could be better utilized in something more productive. When we spend heavily on the maintenance of our vehicle and end up encountering another maintenance issue which requires more expenditure, that we have spent already on the maintenance of our vehicles drives our decision to spend more than replace the vehicle.
Similarly, we get anchored to certain price points which could be the purchase price of our scrip, the high that it made yesterday etc. We end up not buying a scrip as it has moved few rupees where it was trading the day before and lose several times the money.
Investors need to train themselves to ignore the cost of purchase / other price anchors as sunk cost / missed opportunities and be oblivious to them in their investment decisions
High Self rating
A survey concluded that 80% of the drivers rate themselves as above average drivers. Most of the investors rate themselves better than others and their over confidence on their abilities as an investor drives the under-performance of their portfolio.
Our mind tends to process information and give a lot more credibility to data points / news that in sync with our investment philosophy. It strengthens our self-esteem and re-inforces our belief in one self.
We are unwilling to accept and process information that is not in sync with our themes and we discount it as just another view or a stray opinion. It makes us over-look important data points and ignore mistakes which leads to holding of sub-optimal investments. We also end up adding more money to “average cost” in case of price corrections in such scrips to re-inforce our belief in self. It is like putting good money behind bad money.
If we are over-excited about an investment, we are more likely to lose money as we have over-looked risks associated with the scrip.
The most difficult thing is to manage our emotions which influence our decision making, move against the herd and carry conviction in our investments with the humility that we are not infallible and prone to mistakes. These are the hallmarks of a great investor.
Don’t forget to read Real Life Emotional & Cognitive Biases simplified for a Retail Investor