Are you part of the crowd always wondering whether we are in a simulation? Are our thoughts and decisions controlled by an external factor rather than your own? This conversation has become significantly common. In a world that bases its decisions on rationality and irrationality or right and wrong, we question if we are mere puppets in a huge sham project. I believe that one of the main reasons human beings began to study psychology is to comprehend the human mind.
Imagine you visit the farmer’s market to buy fresh fruits. You have to consider the condition of the fruits before you purchase them. Behavior finance follows a similar thought process. Careful consideration and decision-making are involved in familiar parts of our lives, and investment decisions are one of them.
Behavioral financing strays from traditional theories of investment-making. The latter asserts that investments are made after carefully considering the risk-return ratio to help maximize gains. However, the notion of behavioral financing negates this assertion. Rather, it states that several biases influence an investor’s decision-making process.
This blog elaborates on how behavioral financing influences investment decisions across the financial market of India. Not only do investors consider different external factors but also meticulously mine data before making any investment decisions.
Table of Contents
Exploring How Behavioral Biases Influence How Investors Think
The human mind is complicated. It, most often, makes impulsive decisions rather than deciding to think rationally. Besides, the market works similarly. The market fluctuations are unpredictable. Factors of greed and fear are the most common causes of a volatile market. They work in simple ways – the fear of losing money versus the greed of maximizing your returns.
This is exactly how behavioral financing works.
Behavioral finance studies how investment decisions are influenced by psychological factors. It does consider traditional financing methods, and the trough of rational decision-making, but it also considers the individual behavior of investors that ultimately impacts their investment decisions.
The traditional financial paradigm is crucial to understand. However, the notion that humans are rational or economic models always work efficiently, is constricted. Today, the more people study financial decision-making and related case studies, we conclude that emotions, intuitions, intentions, as well as habits, play a major role in finalizing investments.
These behavior biases influence investor judgments, making them crucial catalysts. While they cannot be entirely eliminated, there is a need to underscore the anomalies that can introduce irregularities in financial decisions. Some of these behavioral biases can be outlined as:
Stereotyping
More often than not, investors notice a pattern even when officially none might exist. Hence, investors don’t consider long-term trends or the law of averages. Instead, they take into account the short-term trends i.e., a sudden increase in stock prices or an industry that is performing relatively well as compared to others. This proves how investors’ decisions are based on recent successes and failures through which they generate similar biases in future investments.
Overconfidence
Overconfidence in any situation can be detrimental. Confidence helps investors predict and even secure the maximum possible returns, but overconfidence can lead to overestimation. They might over-value a specific stock, industry, or company ignoring all signs of the same. This can simply lead to excessive trading skewing the results of your investments.
Availability Bias
Is it correct to make decisions based on the most easily available data? You may disagree but investors have been observed doing so. They rely on the recently available information appearing on the news and even word of mouth to make investment decisions. It is easily understood that information through such a channel might not be accurate or reliable. This could potentially result in incorrect decisions. The more recent and significant an event is, it is highly likely to influence your decision-making process.
Anchoring
While making important financial decisions, especially concerning investments, there are several forms to go through, data to analyze, or figures to process. Investors could potentially focus merely on a single figure or available fact due to a restricted timeframe, data load, or less knowledge. This reliance on a specific single factor is known as anchoring. It could lead to a loss or relatively lesser earnings
When you focus on a single fruit in the market, they could lose out on the other delicious fruits that could satisfy their hunger. Similarly, investors tend to base their financial decisions on a single fact – for example, the expected future price of a share – that could harm their returns in the long run.
Conservatism
When new trends are introduced in the market, some businesses readily align themselves with them, and those which take a significant time to adjust. This is a possible behaviour bias of investors that impacts their decisions. The slow-paced tendency to adapt to a belief even after being presented with new information is conservatism bias. Following this, investors continue to react to the market as they previously did and are slow to react to significant changes in the investors’ market.
On the contrary, the same investors may adapt to these changes in the long run and overreact resulting in more instances of misjudgments.
Gambler’s Fallacy
Gambler’s fallacy means the investor’s belief that the market trends will eventually backtrack. As evident from the name of this bias itself, it is similar to what a gambler might face in a casino. If the die has been landing on red numbers for the past three turns while playing roulette, the gambler believes the pattern will reverse i.e., it will land on a black number.
Similarly, investors believe that if a fund is underperforming for a long period, the trend will gradually reverse to provide them with good returns.
The Takeaways: Can Behavioral Bias Affect the Market?
It is understood that most behavioral biases are not actively present in investors. But, there might be some or the other biases that result in anomalies across the financial market. These anomalies destabilize the traditional behavior of the market that assumes that investors tend to be rational while making investment decisions.
It is quite impossible for investors to entirely remove these biases even after inherently realizing their presence. However, there are significant measures that they can ensure to make rational investment decisions.
- Be aware of the behavioral biases.
- Tackle them by making informed decisions.
- Find reliable and authentic data sources.
- Diversify your portfolio.
- Quantify and highlight your financial goals.
- Study and research market trends consistently.
- Track errors and learn from them.
Behavioral financing helps understand the anomalies that behavioral biases introduce in the financial markets. These might not have significant effects, but even this depends on the circumstances. Hence, stock market anomalies are their by-products. This field of study underscores why the anomalies occur even in an efficient market, and how the market itself has diverged from the fundamental ways of investing. Overall, behavioral finance is extremely crucial to study how psychological traits and behavior play a significant role in the investment decision-making process in India.
Please share your thoughts on this post by leaving a reply in the comments section. Also, check out our recent post on: “Things to Remember Before Redeeming Your Investments“
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Disclaimer – This article is for educational purposes only and by no means intends to substitute expert guidance. Mutual fund investments are subject to market risks. Please read the scheme-related document carefully before investing.
