Behavioral Finance: Terms you ought to know

When we invest in the stock markets we are bound to get affected by the psychology that plays in our minds. Do you remember the day when MRF was trading at INR 30,000 in 2014 and you thought the stock was overvalued, because how can a single share trade at such high value, or everyone was labeling that this stock is too overvalued and you were waiting for the stock to fall.

But, not an unusual case, the stock doubled within a few years. You missed the bus. The stock never came back to your expectations. This is just a single case, there are hundreds of stories like this.

As humans, we are bound to take certain calls that are driven by our emotions and not rationale. The moment investment decisions are based on emotions and not rationale, it costs us in a big way.

So in order to master investing you need to take full control of your emotions. Behavioral finance is a great subject that is very close to the psychology of investing. We have listed out some of the important behavioral concepts that as an investor you should know, think, and practice.

If you have missed our previous article. Click here.

Here are the following terms:

1. Round Trip Fallacy: Consider the following statement “ All successful people are hard workers” but should we consider that all hard workers are successful? Definitely not. Working hard is an important attribute to success but not the single one.

Example: All cheap stocks have low P/E. However, if we believe that all low P/E stocks are cheap stocks we are exposing ourselves to the “Round trip fallacy”

2. Representative Heuristic: People tend to judge the probability of an event by finding a “comparable known event” and assuming that the probabilities are similar. As humans, we fall in the trap of representative heuristic. If something does not fit exactly into a known category, we will approximate it with the nearest class available.

Example: If Indigo performs extraordinarily, investors will rush to buy Spicejet. Their representative thinking will make them believe that Spicejet will perform similarly.

3. Myopic Loss Aversion: The pain of a loss is three times more than the pleasure of an equal amount of gain. Investors are not risk-averse, if this was true they wouldn’t have entered the market in the first place. Rather they are loss averse. They will not consider an opportunity where there is a potential loss. For any investment decision to play out well, one should weigh out the risk-reward ratio and then take an investment decision. However, investors become loss averse when even the slightest hint of loss lurks in their minds.

Example: Investors tend to hold on to the losing investments knowing fully well their loss. They tend to sell their winners fast. When markets go down, investors flee the stock markets and go for fixed income securities. These are all examples of myopic loss aversion.

4. Scarcity Principle: In our need to control our world, being able to choose is an important freedom. If something becomes scarce, we anticipate possible regret that we didn’t acquire it, so we desire it more. This desire is increased further if we think that someone else might get it and hence gain the social position that we might have had.

Example: The upper circuit in the stock markets enforced by the stock exchanges creates the scarcity effect. On a particular day when there are more buyers and sellers, the stocks hit the upper price circuit and cannot go beyond it on that day. The illusion of the scarcity leads to more buyers chasing the stock and the next day it again gets frozen at still a higher upper circuit.

The same happens during an IPO, Investment bankers create scarcity while advertising IPOs. Even after knowing that we will get a chance to buy the shares post IPO, we join the mad rush to subscribe to the IPO. It is also not known that most of the IPOs tend to trade at a level below their issue price after the mania in the sector or the bull market ends?

5. Justification of Effort: People tend to work hard in order to be successful. This not only involves making enough money to stay alive and comfortable but also move up in the social hierarchy. How we are perceived by our colleagues and friends has a special bearing on self-perception. With such incentives, it is quite natural that the desire to justify our efforts to ourselves and our peers, as heading toward the right direction is deeply ingrained in our belief system. In the process, we tend to look for evidence to justify our effort.

Example: Some people find it hard to sell a stock because of the effort that has gone while buying the stock. They believe they should wait for the stock to bounce back to rationalize their efforts that went when they first bought the stock. Analyst prepares long reports justifying their investment rationale with a lot of charts and graphs. This makes the research report attractive as a lot of efforts seem to have gone in.

Mastering your mind and taking full control of our emotions can take you a long way. Investing in the stock markets is like watching grass grow or paint dry. It is a long period game, and during these long periods, people tend to fall for the psychological traps that the markets create every day. So in order to make money in the stock markets, one has to master the game of patience, courage, emotion check, and avoiding the mental traps.

Thanks for reading. Happy Thursday 😊