BEHAVIOURAL FINANCE
HOW INVESTORS DECISIONS AFFECTS MARKET?
The equity markets all over the world were hammered badly due to the global recession of 2008. It was the time when many withdrew their investments under the fear of losing all their money whereas others saw it as a good opportunity to invest. But which is the right move? To withdraw or to invest? Here lies the importance of correct decision-making.
The art of decision- making:
The ability to take correct decisions is very crucial for any investor. Decision-making is defined as ?the process of choosing a particular alternative from a number of alternatives?. It is an activity that follows after proper evaluation of all the alternatives. The ultimate objective of an investor is to maximize his return. Since every investor differs from others due to factors like socio-economic background, educational attainment level, age, race etc so their decision-making skills also differs. Depending on this skill there are investors who make huge profits while others make huge losses. Thus, the most crucial challenge faced by the investors is in the area of investment decisions.
The Roots of Behavioural Finance
In the early years, investment was based on performance, forecasting, market timing etc. These produced very ordinary results. There was a huge gap between available returns and actual returns which forced investors to search for the reasons behind this gap.
In the examining process, they identified that it is caused by fundamental mistakes in the decision-making process. In recognizing these mistakes and means to avoid them, they realized the impact of psychology in investment decisions.
Thus, many researchers and analysts began to study the psychological processes driving these mistakes. Ever since then the subject has gained immense importance and academicians call it Behavioural Finance. A number of seminal works had been published on this topic by leading scholars like Werner DeBondt, Malcolm Baker, Robert Shiller and Richard Thaler to name a few. Dr Terrance Odean is one of the leading researchers, writers and lecturers in this field. Today, Behavioural finance is considered an important subject across the world explaining investment decisions of investors.
Behavioral finance is a study which focuses on how investors interpret and act on information to make informed investment decisions. It is a study of investor?s market behavior that derives from psychological principles of decision making, to explain why people buy or sell the stocks they do?
SMART PEOPLE MAKE BIG MONEY MISTAKES
Behavioral finance attempts to explain how and why emotions and cognitive errors influence investors and create stock market anomalies such as bubbles and crashes. Some of the common mental mistakes which investors make unknowingly are explained below:-
Herd-like behavior - This is the most common mistake where investors tend to follow the investment decisions taken by the majority. That is why, in financial markets, when the best time to buy or sell is at hand, even the person who thinks he should take action experiences a strong psychological pressure refraining him to do so. The main reason for this is pressure from or influence by peers. A classic example of this behavior was portrayed in the case of Reliance Power IPO in the year 2008, where majority of people invested without having full information on the issue.
Overconfidence - Although confidence is often encouraged and celebrated, it is not the only factor to success. It is seen that the investors who are cautious and analytical achieves success while others have to suffer losses. Sometimes, investors overestimate their predictive skills and assuming more knowledge then they have indulge into excessive trading which often results into negative results Whenever possible, include timely news so that each edition is fresh.
Representativeness - It involves projecting the immediate past into distant future. Investors are often found to make decisions based on past performance of stocks. However, it is not the correct approach because it does not involves taking into consideration present factors affecting the market. It is rightly said by Warren Buffet that investors who base their decisions on past performance are always at loss.
Anchoring - It describes the common human tendency to rely too heavily, or anchor on one trait or piece of information when making decisions. When presented with new information, the investors tend to be slow to change or the value scale is fixed or anchored by recent observations
“Driving while looking into the rear view mirror instead through the windshield often causes damage” Warren Buffet
Though the above examples of illusions are widely observed, behavioural finance does not claim that all the investors will suffer from the same illusion simultaneously. The susceptibility of an investor to a particular illusion is likely to be a function of several variables.
Behavioural factors play a vital role in the decision-making process of the investors. Hence the investors should always take necessary steps to minimize or avoid illusions for influencing their decision-making and to make safe investment decisions.
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informative.Nice post.
Very informative …..but i think the biggest factor is to have liquid sustainable capital.The ability to sustain your losses and yet stay in the market for long periods of time .It is the long term investor(min 2-3 yrs ) in quality stocks who generally ends up making money .
An informative & useful post…
Realy informative.Nice post.
u r rite,decision making ability is very essential and key for success. I really appreciate u for this useful article.
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Samiksha….Great Job done dear….this type of article not only hepls us to identify potetial risk areas but also provides the solution ….and when the question of somebody’’s hard earned money ..its really a matter of great concern…though i m from thsi field only but i never tried to creat such an article….i m very happy that u have taken this innitiative…..Great job done…Thanks and GOD BLESS YOU.
this is a gr8 post….