- By Yuvraj Dutt Sharma
Behavioral finance can be examined through multiple lenses. While the psychological factors impacting market results and returns are commonly associated with stock market performance, there exist numerous perspectives for observation within this realm. The purpose behind categorizing behavioural finance lies in enhancing our comprehension of the motivations driving individuals' financial decisions and how these choices can shape market dynamics.
In the context of behavioural finance, the underlying assumption is that financial participants are not characterized by perfect rationality and self-control. Instead, they are subject to psychological influences, possessing relatively standard inclinations toward self-control. The process of making financial decisions frequently hinges on the mental and physical well-being of investors. As an investor's overall health improves or deteriorates, their mental disposition tends to shift, exerting an impact on their decision-making and rationality across real-world issues, including those pertinent to finance.
An integral facet of behavioural finance research revolves around the examination of biases. Taking a more granular approach to biases, behavioural finance analysis has revealed a multitude of distinct individual biases and inclinations.
1. Myside Bias: also referred to as confirmation bias, indicates the human inclination to interpret, actively search for, and retain information in a manner that validates their pre-established convictions, viewpoints, or attitudes. This inclination can cause individuals to prefer information that concurs with their already-held opinions while disregarding or overlooking data that contradicts them.
Essentially, my side bias steers people to perceive situations based on their standpoint, further strengthening their existing beliefs and frequently dismissing differing perspectives or evidence. This can lead to skewed reasoning, imperfect decision-making, and the reinforcement of preexisting biases. Let's understand with an example
"Suresh, an investor in banking stocks, had strong confidence that Yes Bank's value would increase. However, due to the Yes Bank crisis, the stock began to decline. Despite the continuous negative news and indicators such as technical charts and fundamentals predicting a drop, Suresh exhibited confirmation bias and continued purchasing more shares. His bias led him to believe he couldn't be mistaken. He initiated his investments with Yes Bank at 87.2 and subsequently at 61.3, followed by another purchase a week later at 45. He persistently accumulated more shares, even as the bank's stock price fell further. As of August 21, 2023, the current price of Yes Bank is 16.95. This situation brings to mind the adage, 'Never average down on a losing stock.'"
2. Recency Bias→Recency bias is a cognitive bias that leads individuals to give more weight to recent events or experiences while downplaying the significance of historical data. In the context of the stock market, recency bias can cause investors to focus excessively on recent price movements and news, often leading to irrational decision-making.
For example, Mr X, a stakeholder in PVR, became an investor in the company due to its robust underlying financials, anticipating significant future returns from the shares. However, with the onset of the COVID-19 pandemic in India, he responded to the news by hastily selling his fundamentally solid stock in a state of panic. Interestingly, the stock's value started to rise again after a few weeks, illustrating an instance of recency bias.
To counter recency bias, investors should practice disciplined research and decision-making. This includes conducting thorough analyses of a company's financials, considering a stock's long-term historical performance, diversifying its portfolio, and avoiding making impulsive decisions based solely on recent price movements or news.
3. Loss aversion: It is a psychological bias that refers to the tendency of individuals to feel the pain of losses more intensely than the pleasure of gains. In the context of the stock market, loss aversion can significantly influence investors' decision-making and risk-taking behaviours.
Due to the aversion to losses, investors often hesitate to sell a stock that is currently trading at a loss, even if the stock's prospects appear unfavourable. They may hold onto the stock in the hope that its value will eventually rebound to at least their purchase price. Let’s understand through the same example of Suresh as mentioned earlier.
Despite the ongoing stream of unfavourable news and signals like technical charts and fundamental analysis pointing towards a decline in Suresh's portfolio value, he exhibited a bias known as loss aversion. Despite witnessing a substantial decrease in his portfolio's value, he hesitated to sell his shares during the early stages of the downturn, ultimately resulting in a significant loss by the end.
In conclusion, behavioural finance offers a multifaceted perspective on the complex interaction between human psychology and financial choices. While the impact of psychological factors on stock market performance is well acknowledged, this field delves into various dimensions.
Within behavioural finance, the central idea is that market participants are not consistently perfectly rational and self-controlled. Rather, they are influenced by psychological factors and exhibit shared tendencies toward self-control.
One key focus in behavioural finance is biases. This exploration of biases reveals an array of individual biases and inclinations that shape financial decisions. By acknowledging my side bias, recency bias, and loss aversion, investors can aim for greater rationality, reduce emotional influence, and develop strategies aligned with long-term financial goals. In essence, behavioural finance equips investors to navigate the intricate landscape of financial decision-making more effectively.
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