Behavioural Finance: Investors do react to newsflow

The recent correction in the stock market has send shock waves down the spine of retail investors. Many of them who have entered the markets at higher levels are frantically calling their brokers/ advisers on the future course of action. This behaviour can be explained by understanding the concept of 'Behavioral Finance'. Behavioral Finance, is a study of investor market behavior that derives from psychological principles of decision making to explain why people buy or sell the stocks they do. Behavioral finance places an emphasis upon investor behaviour leading to various market anomalies.

Contrary to popular belief, studies reveal that  investors perceive bad news as less credible (i.e., are more optimistically biased) than good-news management forecasts and discount bad news accordingly. For this particular reason, investors remain in a denial mode in discounting the bad news in respect of the stocks that they hold. Behavioral finance tells us that most investors are most vulnerable to losing their principal investment, and thus continue to hold onto a particular stock, more so when adverse conditions have pushed the stock price below their purchase price. They are always hopeful that the market would reverse sooner than later, and they will recover their original cost. This behavior is also the stepping stone of 'Technical analysis', taking into account the support zones of stock prices.

But the bad news is discounted by the investors/ markets, albeit with a time lag. What we are witnessing now is the reaction of the investors to all the accumulated bad news. In the recent bull run that continued till Diwali, investors continued to ignore both international and national bad news when it unfolded initially. The Greek debt crisis and the slowdown of industrial production in India, were initially shrugged aside and the markets continued their upward march unabated. It took the unfolding of the political scams in India to put brakes on the markets. It is fortunate for the investors that the much awaited correction has started, which gives an opportunity for investors to re-enter the markets at lower levels. Await some more bad news to get discounted, before committing large funds into the equity markets. A 10-12% correction from the recent highs will be good for the long term health of equity markets.