Behavioural Finance: its pitfalls for Investors

Behavioural Finance is the study of rational/ irrational behaviour of individuals which influences market prices, returns and allocation of resources. It attempts to understand how people forget fundamentals and make investments based on emotions.
The primary objective of all investments is to maximize returns and create wealth. Observing the behaviour of individuals leads us to believe that people are very often ruled by emotion (greed and fear) rather than by logic. They display imperfect rules of thumb (heuristics) to process the available data, thus bringing in individual biases in their beliefs, leading to commitment of fatal errors of judgement.

The important heuristics driven biases are:

• Representativeness – Forming an opinion of future action based on past performance. Investors may tend to rely on certain patterns in the past data that are random.
• Overconfidence – The human mind is trained to extract the maximum information from the available data, but it may not be adequate to arrive at an accurate forecast in uncertain market conditions. This phenomenon is described as ‘self-attribution bias’, where people tend to attribute their success to their investment skill and their failure to bad luck.
• Anchoring – Conservatism or the inability to change an opinion after subscribing to a fixed idea, often manifests in a failure to react to a new information which is relevant to one’s investment but does not match with his/her subscribed opinion.
• Innumeracy – This results from ‘mathematical illiteracy’ where people tend to misunderstand the statistical data. Generally, people tend to give more importance to big numbers and tend to overlook small figures.

Investors often fall prey to their own and sometimes others’ mistakes due to the use of extreme emotions in ‘Financial decision making’. If you compare the overall profits of traders, you will find that they make similar profits as long term investors. This is because they tend to pay huge fees such as brokerage, transaction charges, short term capital gains. You as a long term investor may be able to earn a higher return, in addition to the peace of mind.

So, the next time if one of your friend suggests a great investment opportunity, naming a ‘ten bagger’ or a ‘multi bagger’, just ignore it. When the market has crashed, the same set of people will create a panic by telling you to sell, just hold your emotions. Do not get carried away by extreme sentiments, because they bias your judgement and can only help you to make blunders. Have firm faith in yourself, and make your investments based on confirmed information and objective analysis of the same.
Remember: Money cannot buy happiness, but the lack of money can buy a lot of misery.