What is Behavioral Finance?
For all those investing in stock markets, you might be aware that Investors usually put and call on the basis of their fundamental and technical analysis of the share prices over a period of time. This is usually done to predict the future or intrinsic value of the share to know whether the stock is currently overvalued and undervalued. However, does the market price depicts the true value of a corporate firm?
And why not?
As per the traditional approach, investors are assumed to act rationally using the information available and analysed. The markets are assumed to function effectively and efficiently. This is an efficient Market hypothesis. However, over time the concept of behavioral finance has gained traction. It assumes that investors are self controlled and not perfectly rational. It is an area of finance describing stock markets being impacted by the psychology of Investors which in turn influence market outcomes. Investors are influenced by their own biases due to which they make errors leading to wrong decisions. This approach is different from traditional approach and is an observed outcome of behavioral scientists.
Behavioral Finance theory differs from traditional approach as it assumes that:
Investors are normal but not always act rational.
They have limit to self-control and have personal biases
Investors can take wrong decisions due to presence of cognitive errors.
These biases can be categorized into following buckets:
1. Self Deception:
When an Investor tends to feel that he knows more than he actually does, he tends to be miss informed that leads to biased and wrong decisions. This sometimes limits the way you learn.
2. Social Influence:
Investing decisions can be influenced by family, relatives, friends and how others are making their investment decisions.
3. Emotional gap:
It is a factor that influences rational decision making. This refers to decision making based on extreme emotions or the current emotional state.
Investors are also meant to mimic the financial behaviors' of the majority of the herd which is known as herd behavior. Behavioral Finance people are referred to as ‘normal’. As the concept of behavioral finance gains acceptance, efforts to influence Individual and market behavior have increased.
Investors appear to exhibit bias in decision making, base decisions on the actions of others and not evaluate risk and return themselves. Investor irrationality is considered a reported underlying cause of the same.
Loss Aversion, being the tendency of investors to be more risk-averse when faced with potential losses is an indicator of investor irrationality. Apart from this, Investor overconfidence being the tendency to overestimate their abilities to analyse market information and herding simply meaning mimicking the investment actions of other investors are also an indication that investor irrationality exists. An Information cascade occurs when the less informed investors follow the actions of informed investors, which helps to move market prices towards the intrinsic values improving informational efficiency in the long run.
Even a rational investor can get affected by these biases and earn a return much lower than the market indices. Investors who have a particular strategy to avoid these behavioral biases are able to earn a better return.
So, how to overcome behavioral biases which act as an obstacle to investment success?
Seeking Confirmation biases as a way of validating their investment decision while avoiding opposite views can result in a significant loss to investors following this approach. Instead, you can adopt a strategy of looking at the contradictory points and then evaluating your strategy and related decisions.
Don’t develop attachment to a company or a stock. Follow the risk and return analysis to invest in a particular stock as a company might not always be “great” providing successive returns.
Past performance does not guarantee a future financial success. Don’t just blindly cling on to a share, based on a good past performance.
The fear and the pain from investment loss is greater than the satisfaction of the gains. Emotions might lead to biased and uninformed decisions. It’s important to manage your emotions while investing.
Following the herd is a bad idea as imitation may end a successful investment strategy. Do your own homework and don’t just blindly follow market sentiments.
Pay attention to a detailed analysis and don’t believe stories meant to diverge realities.
Prepare, Plan and Commit before you invest. Either go with your reflexes and trust your instinct or adopt a reflective approach and invest using logical and methodical methods.
Behavioral Finance explains how market security prices deviate from rational prices and is a biased estimate. But markets are not said to be inefficient even if investor irrationality exists unless it is a prerequisite to achieve market rationality.
“Investing success doesn’t correlate with IQ after you’re above a score of 25. Once you have ordinary intelligence, then what you need is the temperament to control urges that get others into trouble.” - Warren Buffet