The Varied Effects of Behavioural Finance

“Las Vegas is busy every day, so we know that everyone is not rational”

-?????????Charles Ellis

As humans we are bound to be irrational at times as Human Behaviour is complex and at the outset investors were primarily being termed as irrational as the choices they made were supplemented by a range of fears. It was around the mid of 1970s – 1980s when economists understood that investors always do not function rationally as per the Efficient Market Hypothesis and introduced the term Behavioural Finance.

Behavioural Finance refers to the influence that psychology holds on investors. In other words it studies the effect of how people tend to make decisions against their self interest using their personal bias instead of relying on plain vanilla facts. It is also a subset of Behavioural Economics.

Behavioural Finance makes it easier to comprehend how our choices with respect to our risk appetite, debt, investments etc. are influenced by human emotions and cognitive biases. It plays a very crucial role as psychology plays a pivotal role in in our ability to build wealth.

An example of how a Bias might work is how the markets bounced back after seeing a sharp fall owing to the Covid-19 Pandemic. But assuming that Investors will react in a similar way if another Black Swan event happens, might go the wrong way due to the irrational effect of a Bias.

After knowing what a Bias is, it is important to understand what are the different kinds of Biases that might be impacting our Financial Decisions and how do we make more rational and prudent decisions instead.

The different types of Biases are

a)?????Loss Aversion Bias

This Bias basically deals with the tendency of avoiding Losses than exercising gains of the equivalent nature.

Example – A wins a lottery for $500, and is happy with the $500, but if you win $1000 and the next day you are robbed of $500, you will be upset with it, however in both cases the net gain is $500. This can be similar to Investing in an FD rather than investing in Mutual Funds?

b)?????Anchoring Bias

Anchoring essentially means relying on the first piece of information that was received regarding a particular product and not pay heed to the subsequent information received or reference everything to the information received in the beginning.

Example – Comparing a share’s 52 week high price to its current price to decide if it will be a good buy/sell point. We will have to look at the rise/fall objectively and analyse the reason for the impact it is creating on the price of the share.

c)??????Herd Mentality Bias

Also known as the “Bandwagon Effect”, Herd Mentality Bias refers to the tendency to presume something is right just because people are doing it without understanding the cause and effect of the same. It is also caused due to the Fear of Missing Out (FOMO)

Example- The best example to substantiate Herd Mentality would be the shooting Price of Game Stop around January 2021. There was no change in the company’s operations and yet the prices went up as users of Reddit decided to buy a lot of shares in order to increase the price.

d)?????Confirmation Bias

Confirmation Bias is the type of Bias where investors look for more evidence to rationalize the pre-existing knowledge that they had on a given topic. It essentially acts as a confirmation to the information already possessed. This can be a problem because the investors tend to oversee the information that is conflicting their opinions.

Example – If an investor wants to sell a stock and the next quarter’s numbers are going down due to a marketing strategy to target customers from Tier III cities, the investor is then going to sell the stock solely based on the fall in the numbers without understanding what has led to the decline in the price of the stock.

At the Bottom Line we can arrive at a consensus that markets react irrationally because of two major attributes namely “Fear and Greed” and letting these emotions overpower facts and rationalism can cost every investor a fortune.

The solution for this would be to lay a greater emphasis on the fundamentals of a company, ignoring the trends by not blindly following the sentiments of the market and staying invested in the market for a long time.