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Psychology of Investing

Posted on: October 29, 2021 | By: Shailesh Khatri

While most of us may find this topic common or repetitive but it is the very need of the current state of Markets to understand the Psychology of Investing or the Behavior of various Investors to make better decisions when it comes to our Money.

The Psychology on investing decisions can be well understood from the study of the theory of “BEHAVIOURAL FINANCE”

After reading you might feel that “Behavior” and “finance” are two different things. How can they be interlinked in the same phrase?

Behavior is all about emotions, personalities, psychology, and sociology. And finance is all about numbers, equations, statistics, and balance sheets.
The most common assumption of standard finance is that human beings are “rational.” This means that humans analyze the pros and cons of any situation and then choose the one which is best for them. But the critical question is, are we rational?

Let’s look at a common example and understand – Suppose two restaurants open next to each other: Restaurant A and Restaurant B. The very first customer sees two empty restaurants and chooses the one to eat at based only on their appearance. Let’s say he chooses restaurant B. The second customer sees one person eating at restaurant B and an empty restaurant A.

Then, he will make his choice based on two things. First, the appearance of each restaurant, that’s his information, and secondly, the fact that the first customer chooses restaurant B, which is external information. If the second customer chooses to go to restaurant B, then the third customer will see two people eating at restaurant A and an empty restaurant B. as people continue to join the crowd and prompt others to do the same. Eventually, each customer might end up at restaurant B, which might even be the poorer one as compared to restaurant A.

What has happened in the above example is that people have ignored their information. And that creates a distorted signal chain. We think that everyone has made an informed decision, and that decision appears to have value. But in reality, everyone’s decision is based on the decisions made by others. And because of this, our decisions contain no real valuable information.

The behavior displayed in above example is called Herding means following a group, and this also applies to individual investments. Before investing their money, individuals take suggestions/ are influenced from different people, which may include parents, colleagues, friends, or maybe cousins or are influenced by social media posts, newspaper articles etc. They try to understand how they are investing their money, and in what kind of instruments they invest and so on.

Stock markets get greatly affected by this herd mentality.
In the past few years, a lot of people have started practicing investment. While most of these investment decisions are based on research and logic, some decisions are a result of our sentiments or instinct, and chances are, there may not be any logic behind that.

Do you know what this is called? Or why people make these types of decisions? Behavioral Finance goes further and explains this.

What is Behavioral Finance?
In simple terms, Behavioral Finance is: Psychology + Finance

The behavioral economic theory states that:

  • Markets are inefficient.
  • Humans are irrational.

Behavioral finance helps us understand that our mind is one part, and our heart is another part of making choices or decisions.
The origin of behavioral finance can be traced back to the 1990s, and Daniel Kahneman, along with Amos Tversky, gave the essential theories of behavioral finance. They also got the Nobel prize for the same in the year 2002.

The two pillars of behavioral finance are cognitive psychology (how people think) and the limits to arbitrage (when markets will be inefficient).

Traditional Finance vs Behavioral Finance:
There are various criteria on which we can identify the difference between standard finance theories and behavioral finance theories.

One such aspect is Risk; the standard finance theory considers risk as an objective term that risk can be quantified. Risk can be calculated as beta, or risk can be calculated from the standard deviation.
But behavioral finance theories say that risk is subjective. One person can have a different level of risk-taking capacity than another person, and it cannot be objectively measured. Also, there are differences in the two theories concerning the Return.

Standard finance assumes that risk and return has a linear relationship; that is, if risk increases, the return will also increase but behavioral finance says that there is an inverse relationship between perceived risk and perceived return. Here we are not talking about actual risk and actual return, because it is a personal risk. So the risk is perceived, and return is also perceived return.

Most investors while Investing worry about Risk that cannot be controlled or managed and perceive returns based on their assumption of Risks based on various biases and information. Such Behavior makes it important to study and understand Behavioral Finance.
Summing it all up

You might have heard a common phrase that “Even smart people make Big Money mistakes.” Well, this is true Because IQ has nothing to do with money mistakes. It’s the EQ (Emotional Quotient) that influences or behavior and decision making as it is explained in different behavioral finance theories.

Behavioral finance suggests that the structure of information and characteristics of participants of the market can play an essential role in the decision making of the investor as well as the overall outcome of the market.
Behavioral Finance is about making the right decisions that are free from any kind of biases and errors. It helps in understanding investor behavior better and helps in improving the financial capability of individuals.
People can earn better returns if they know what the biases which are affecting their decision making are, and thus they can make better decisions.

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