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Does your financial behaviour impact your investment decisions?

Does your financial behaviour impact your investment decisions?

Most readers would pride themselves as rational individuals regarding investments they believe are taken after much thought or deliberation to give maximum returns. This article tries to analyse the economic behaviour of investors and provide suggestions to reduce their specific financial behavioural biases that may affect investment decisions. Behavioural finance studies how psychology affects the financial decision-making process, emotional or cognitive (i.e., decisions with deep intellectual thinking) by an investor in the financial markets. Such studies explore human judgment and provide essential facts about how human actions may differ from the economic or mathematical assumptions made by the investor before his investment.   

Basic behavioural factors

Some of the basic behavioural factors that may affect an investment decision are:

Fear: Most people exhibit the fear of losing their money. This loss aversion results in a “freeze” – an inability to take decisions to invest or exit an investment. It may even result in more profound losses due to inaction or lost opportunities which then may translate into FOMO (or the fear of missing out).

Love: Many people “fall in love with” shares which had earned them handsome returns earlier and end up retaining them for a long time, despite various market changes impacting the underlying assumptions or calculations when the investment was first made. After exiting these shares, others may renter their positions even though the underlying assumptions that produced profits earlier have changed. This applies equally to other assets, such as the latest car, house, or dress in which the cost-benefit analysis study is junked. This satisfies a latent desire over the years to acquire the asset. It may be a bad idea if you are in love or excited about an investment or a purchase. An example is an IPO in which excitement is built up through marketing, and then one invests through herd instinct without studying the prospectus, only to lose money when the shares are listed.

Greed: It may be seen that greedy people can buy heavy-priced shares or buy large quantities of the shares without proper calculations on appropriate sizing. It may also be seen that people who have achieved their goal may not exit the stake and book timely profits due to greed that they will earn better returns in the future. These may lead to bubbles which collapse later. Researchers cite the Tulip Mania and the South Sea Bubble, in which the lifetime fortune of even an intelligent investor like Sir Isaac Newton was decimated. Newton is said to have remarked after his financial losses that he could “calculate the motions of the heavenly bodies, but not the madness of people.”

High optimism: This phenomenon is not backed by reason. Highly optimistic people often go into the market without a logical explanation. This may result in a market correction or collapse of the market outcome. The investor may remember Warren Buffet’s admonition – “To be fearful when others are greedy and greedy when others are fearful”.

Herd instinct: People who think less may follow others’ lead. The investor may track the leader, who may be a trusted investor or peer. Other investors may react to every financial expert’s opinion in the financial press or television and begin doubting their investments, resulting in an inefficient investment or loss.

Exciting investing: Financial behavioural experts say NO to exciting investing. As one behavioural researcher has used the acronym, HALT – never buy or sell anything when you are Hungry, Angry, Lonely or Tired, as these emotions affect your rational nature. It is better to avoid buying or purchasing when afflicted by these states.

Information bias: Some investors use forecasts by experts to calm their brains. The vast amount of information from various sources such as TV, websites, and YouTube ultimately causes information fatigue. Since there is a limit to the brain absorbing large tracts of information explosion, one later tends to ignore all information, even losing sight of changes in macroeconomic or corporate indicators useful to one’s investment plans. One may need to learn to filter out what information is helpful in one’s investments.

Action bias: Investors believe they should take time by timing the market, whereas research has shown “it is not timing the market but time in the market”, which may give superior returns.

Anchoring bias: If one sees a US$ 1,200 T-shirt and then a US$ 100 T-shirt, the US$ 100 T-shirt seems cheaper. If one had not seen the US$ 1,200 T-shirt, one might have no view on whether the T-shirt is cheap or expensive. This is called the anchoring bias. If one deals with a higher-priced share, we may see a less-priced share as worth investing in. One needs to check the share’s intrinsic value and not be affected by the anchoring bias.

Overfocussing on winning transactions: The tendency to overfocus on the strategy applied in a recent winning transaction. For example, one may have invested, say, in a paint sector stock when the price of crude oil, one of the essential ingredients in paint manufacturing, was low. One might have won handsome gains earlier, but applying the same winning strategy when crude oil has skyrocketed due to changes in geopolitics or wars would be
counter-productive. 

Gender bias: Men choose risky portfolios and trade more than women in the market. Women making investment decisions may not be as optimistic and confident about themselves as men. Women are more likely than men to perceive that they have too little investment experience and refrain from investing.

Learning and eliminating biases

Learning from one’s financial behaviour issues: The key to successful investing is not decision-making based only on financial knowledge but also on identifying and reducing psychological errors. In a book or diary, one must write down the rationale applied to investment, including the calculation of return, the holding period, etc., after each transaction. In addition, it is essential to understand the peculiarities of one’s behaviour finance features to understand better and recognise the effect of behavioural finance. Once you focus on your financial behaviour and your biases through the medium of your recorded notes, this becomes your basis for corrective action to avoid the impact of your preferences and quick trigger-like response in the future. 

Remember what Victor Frankl, the Austrian psychiatrist, once said, “Between stimulus and response, there is a space; in that space is our power to choose our answer. In our response lies our growth and freedom”. 

Consequently, in all markets, you control what matters most. Don’t say, “I could not avoid that stock purchase or sale.” Remember, in between the trigger
(the stimulus) that causes you to buy or sell in a panic and press the sell or purchase button (your response); you have a space to check whether the motivation is factual and whether you have decided or your bias has decided for you. In that area lies your power to choose between financial freedom and otherwise.

After logging in to your diary, you will likely overcome those biases once you commit to changing your behaviour. But, of course, one may not overcome these ingrained lifetime habits overnight. Still, identifying and then committing to eliminating these biases will go a long way in ensuring the returns from your investments and meeting your financial plans. Thus, minimising or eliminating the risk of not meeting them by the dates set by you.

Article: RK Menon