- A multidisciplinary field, behavioural finance derives excerpts from sociology and psychology to elucidate financial behaviour.
- Research shows that investors are often their own worst enemies, impairing themselves by making emotional decisions or resorting to performance chasing and market timing.
- Vanguard research and related academic studies reckon that behavioural training can alone add 1 per cent to 2 per cent in net return.
It is often said that an investor’s worst enemy is himself.
Behavioural finance acknowledges that no one is rational, logical, or well-informed. Investors often take tips from friends and peers; hate losing a dollar and may cease to adopt new information. To be a successful investor over the long term, it is critical to understand, and optimistically overcome, common human cognitive or psychological biases that may lead to poor decisions and investment mistakes.
A report by the Securities and Exchange Commission states that behavioural finance incorporates observable, systematic, and human departures into standard models of financial markets.
Why Is Investor Behaviour Important To Understand?
Investor behaviour is an essential area to acknowledge because it explains social, cognitive, or emotional factors that may propel investors to depart from the rational behaviour that traditional economists assume. The field is perhaps the only one that rightly advocates an important fact- investors tend to fall into predictable patterns of destructive behaviour and may make the same mistakes repeatedly.
By recognising and explaining patterns of poor investment decision making, behavioural finance has contributed to the general understanding of investment behaviour. Besides, the field can help educate investors and prevent them from committing a predictable series of mistakes. Market experts even advise that investment professionals consider the findings of behavioural finance when they advise clients and vigilantly monitor their accounts.
ALSO READ: Behavioural Economics
What Are Common Behavioural Mistakes?
It can be challenging for the majority of investors to remove the emotional aspect of making investment and trading decisions. Behavioural investing errors can prevent investors from following through on long-term strategies. As deciphered, behavioural mistakes are common to the world of investing.
A number of investors make detrimental decisions with regards to their portfolios by under diversifying, following the herd, trading frequently, preferring only domestic stocks (familiarity bias), selling winning positions and holding onto losing positions (disposition effect), surrendering to optimism without knowledge, overconfidence (self-attribution bias) and short-term thinking.
The mistakes do not end here! Read on-
- Loss aversion– Humans will always choose to avoid losses over the option of obtaining equivalent gains. The constant fear of loss may propel an investor to sell winning securities, way in advance. Besides, FOMO may even cause investors to hold onto losing securities for longer periods.
- Momentum Investing- This is a common investment strategy. While practising this, investors purchase securities with recent high returns. They sell the ones that have recent low returns. In the act, he/ she expects that previous trends will continue- which not necessarily is a reality.
- Noise Trading- Noise trading, as the phrase suggests, describes the activities of an investor who makes a choice to buy or sell securities without the help or understanding of fundamental data.
Other common mistakes include-
What Should Investors Do?
We have so established the fact that investors, like all humans, look for patterns. And sometimes, the hunt for patterns can get investors into trouble, especially when pattern-chasing tendencies lead them into making incorrect decisions, at the wrong times. What follows is the mistakes outlined above, what Shakespearean fans may call “a comedy of errors”!
But there is a silver lining to almost every aspect of investing.
It should be believed that investors cannot solely control the markets. But they should not forget what they can control, or at least help control— their investing behaviour. Let us understand a few ways in which investors can avoid making common behavioural investing mistakes-
It is true that investing invokes emotion and will continue to do so, thanks to human nature.
Most recently, the COVID-19 market volatility caused immense mayhem- panic selling was rampant, circuit breakers were launched, and stock market sinusoidal trends were overwhelming. To tackle this, a long-term perspective and a disciplined approach are the time-tested principles that seasoned market participants continue to practice because- the show must go on!
In closing, we would like our readers to understand this- an investor’s long-term investment success is widely determined by his/ her ability to control ‘inner demons’ and ‘psychological traps’. Once the investor recognises these ‘inner demons’, that are the behavioural investing mistakes, he/ she can develop approaches to tackle them and welcome significant investment gain.
As the quote goes -