Understanding Behavioural Finance & Investment Decisions

Understanding Behavioural Finance & Investment Decisions

Investment decisions in the context of businesses/corporations are associated with capital budgeting, capital allocation and management of resources, etc.

However, investment decisions in light of personal finance are concerned with the allocation of our capital in purchasing assets in expectation of a return. Asset classes that are usually pursued by us include real assets, precious metals, equity, fixed income investments etc.

As humans, our investment decision-making is influenced by numerous factors, including savings, earnings, expenses, commitments, debt, goals, age, risk-tolerance, solvency etc.

So, what influences our personal investment decisions?

Risk tolerance

A self-assessment of risk-taking capacity allows us to make informed investment decisions that are crucial in achieving desired targets or meeting our own expectations.

Moreover, it means assessing how much you can afford to lose in your investments. Thus, the investment decision-making is often shaped by the risk-tolerating capacity of investors.

Investible Headroom

Or surplus, it means the residual capital with yourself after allocating for necessary expenses and commitments. Also, it is your budget allocation for investments, planning and financing your future needs of capital.

A surplus depends on our earning capabilities, growth, expenses, commitments, etc., and maybe, it could be inconsistent sometimes owing to changes in underlying fundamentals that drive our earning capabilities (inflow) or commitments (outflow).

Allocation

Allocation of our surplus capital in buying assets belonging to several classes in a bid to achieve a cash inflow or capital appreciation is impacted by the two aforementioned factors as well as access, knowledge, opportunity costs etc.

Capital allocation is also dependent on the strategy that will be pursued to achieve desired targets, returns or to meet self-expectations.

Potential returns across asset classes vary in an extensive fashion, and investors are offered with numerous alternatives. Thus, a range of opportunities in the investible spectrum might impact our investment decision making.

But there are additional considerations that influence investment decision-making significantly.

Behavioural Finance has emerged as the study of human psychology emphasising on the financial decision-making of all of us. Legend like Adam Smith had argued in his work that the morality of humans tends to influence social, economic and financial decisions.

Daniel Kahneman and Amos Tversky are known to be the inventors of the subject of behavioural finance. The duo revamped the narrative on the world on stocks, and our attitude on stocks and thus, behaviour.

It is observed that Behavioural Finance is an evolving field of study as theorists have argued that investors tend to act in directions contradicting the assumptions made under the traditional finance theories.

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In traditional finance theories, it was assumed that the investors are well informed, careful, consistent and come across very minimal difficulties while executing financial decisions.

Initially, Kahneman & Tversky noted that mean regression drives stock prices in the short term, and later, the duo came up with behavioural biases that make humans act illogically against their own interests.

Theorists of Behavioural Finance suggest that investors are oversensitive to losses and overconfident of making gains, and psychological researchers have conducted their studies the world over and have come up with a range of decision-making behaviour known as biases which seek to explain what and why investors do what they do.

some popular biases among psychological theorists on investing.

Overconfidence

Psychological theorists have found that humans have unnecessarily higher confidence while executing a decision, and that overconfidence is a trait present in most of the people in this universe.

Humans tend to view the world optimistically, which is favourable at times, and can cause bias when making financial decisions.

In investing, the overconfidence bias can have influences on decisions that involve a forecast, and investors could overestimate their ability to identify attractive investments. It may be the case that an investor has underestimated the downside risks.

It is said that some investors could have unrealistic belief in their abilities, which results in outcomes against their own self-interests. Also, it is believed that high-frequency trading could be a return detractor.

It is also said that ‘self-attribution bias’ could fuel overconfidence in human beings. A self-attribution bias means when humans encounter positive results due to their decision and start viewing those results as a sign of their abilities. Whereas, when results are negative, humans might view it as misfortune or bad luck.

Loss aversion

The traditional financial theory emphasises on the risk and return trade off, which argues that a higher risk compensates with a higher return, and a lower risk offers a lower return.

Theorists in Behavioural Finance have a view that investors are more susceptible to losses as against risk or return. Investors have the tendency to book profits when the value of an investment is on the rise. However, when the value of the investment is falling, investors would wait to see if they could achieve a break-even.

Hence, investors are likely to portray risk-averse behaviour when the value of investments is on the rise, and when the value of the investment is falling, investors are likely to hold on to the investment until break-even, depicting a risk-tolerant behaviour.

Disposition effect, which was coined by Professors Shefrin and Statman, stated that investors are likely to hold losers and sell winners.

Portfolio construction

Financial theories say that all investment should be treated collectively in terms of a portfolio. A portfolio of investments allows the investors to offset risks among individual investments.

Therefore, investors should assess their wealth collectively as against assessing the individual investments in a portfolio. Whereas, investors tend to focus on individual assets or stock/security.

When reviewing a portfolio, investors are likely to stress on individual asset classes, and a narrow view might increase the sensitivity towards losses. And, the performance assessment of the portfolio at an aggregate level with a wider viewpoint would allow an investor to display capabilities to sustain short-term losses.

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Mental Accounting

Investors often create segregated portfolios depending upon their goals. Each goal has a time horizon which results in variable risk tolerance for each segregated portfolio.

Moreover, the mental bias is created when investors categorise collective assets into different mental accounts, even though the money is the same regardless of its use.

Shefrin and Statman’s behavioural model argues that investors are likely to reflect risk-averse and risk-tolerant behaviour simultaneously across the segregated portfolio, which is designed to achieve a desired target.

As a result, investment decisions like capital allocation across assets with varied return potential, undertaken by investors, could influence the mental accounting bias.

Affinity Bias

Affinity bias refers to the investors’ escalated conviction on certain investments that reflect their own set of values. It is an emotional bias that results in irrational choices or investment decisions, which could be unremunerative for investors.

As an example, the investors’ perception towards environmental, social, and governance (ESG) is increasingly gathering pace, however, an environmentalist is likely to favour companies which are managing ESG risks efficiently.

Recency bias

In this bias, it is said that the investors tend to place greater emphasis on developments that have occurred in the recent past, and often, these developments shape the upcoming decision of investors.

Thus, the investment decisions might reflect a conviction that has ignored consideration of historical developments and which could well affect outcomes in the future.

what’s the essence?

Investment decisions are influenced by a range of considerations that are necessary to achieve the desired targets or goals. And, Behavioural Finance enables an investor to undertake decisions that are directed towards the realisation of self-interests.

It allows an investor to make better decisions and adds to the conventional wisdom in investing. Blending these concepts of Behavioural Finance along with traditional investment principles could actually yield better outcomes.


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