Points to note over here and Possible Scenarios:
This article is written by CA Harsh Saraswat , He is a Chartered Accountant and an Equity Enthusiast and can be reached at firstname.lastname@example.org , His twitter handle link is https://twitter.com/harsh_jaipur.
As the history goes it is believed that we all are rational human beings and strive to maximize our wealth prudently. However when it comes to stock markets it is noted that at many instances emotions and psychology influence our decisions, causing us to behave in unpredictable and irrational ways.
As Benjamin Graham quotes it “Markets are more psychological and less logical”
Behavioural finance is a new field of finance which with itself combines psychology, economics and finance to find explanations about the irrational decisions made by people in financial markets.
Few of the Significant Biases which can be noticed very vividly in markets are :
- Confirmation Bias
- Loss Aversion Bias
- Ownership Bias
- Gambler’s Fallacy
- Winner’s Curse
- Herd Mentality
- Anchoring Bias
- Projection Bias
Lets Discuss all the biases one by one :-
This is one of the most common biases we will find in the markets. It is basically a tendency to search for reasons and information that confirms one’s beliefs or hypotheses. It mostly happens when a trader is holding on to a loss position, when a trader takes a position for a reason and that reason doesn’t works out then such trader looks for more reasons to justify his position so that he can hold on to that position. Such Bias intensifies when a trader is holding on to a loss position as booking out a loss is much tougher job psychologically. This below picture explains the situation quiet well.
If we extend this bias it also gives rise to In-group bias, It is a tendency where we surround ourselves with those who share the similar takes on our outlook. Not only does this provide a false sense of security in our individual viewpoints, it makes us suspicious-or angry-with outsiders who dare to question how we feel.
Loss Aversion Bias
Loss aversion refers to investor’s tendency to strongly prefer avoiding losses to acquiring gains. The fear of loss leads to inaction. Studies show that the pain of loss is twice as strong as the pleasure of gain of a similar magnitude. Investors prefer to do nothing despite information and analysis favoring a particular action that in the mind of the investor may lead to a loss. Holding on to losing stocks, avoiding riskier asset classes like equity when there is a lot of information and discussion going around on market volatility is manifestations of this bias. In such situations, investors tend to frequently evaluate their portfolio’s performance, and any short-term loss seen in the portfolio makes inaction their preferred strategy.
It is a very common tendency among immature investors to book small profits and hold on to bigger losses hoping that their prices will come back soon.
Things owned by us appear most valuable to us. Sometimes known as the endowment effect, it reflects the tendency to place a higher value on a position than others would. It can cause investors to hold positions they would themselves not buy at the current level.
This commonly leads to not selling a stock even when all the indicators suggest that such stock should be sold.
Predicting absolutely random events on the basis of what happened in the past or making trends when there exists none. It is the mistaken belief that if something happens more frequently than normal during some period, then it will happen less frequently in the future, or that if something happens less frequently than normal during some period, then it will happen more frequently in the future (presumably as a means of balancing nature).
It is very well visible in Indian Stock markets also, the leaders who were leading the 2008 rally are now in the junkyards and people who fell for such bias are sitting on heavy losses. It will be the eighth wonder if the likes of DLF , Unitech etc. see their 2008 peaks again.
Tendency to make sure that a competitive bid is won even after overpaying for the asset. While behaviourally it is a win, financially, it may be a loss.
It is basically overestimating the value of good and then ending up worse off than the losers, it is more linked with error of judgment.
The winner’s curse says that in such an auction, the winner will tend to overpay. The winner may overpay or be “cursed” in one of two ways: 1) the winning bid exceeds the value of the auctioned asset such that the winner is worse off in absolute terms; or 2) the value of the asset is less than the bidder anticipated, so the bidder may still have a net gain but will be worse off than anticipated.
This is a common behavior disorder in investing community. This bias is an outcome of uncertainty and a belief that others may have better information, which leads investors to follow the investment choices that others make. Such choices may seem right and even be justified by short-term performance, but often lead to bubbles and crashes. Small investors keep watching other participants for confirmation and then end up entering when the markets are over heated and poised for correction. Most of the individuals don’t go against the crowd as economist John Maynard Keynes said: “It is better for reputations to fail conventionally than to succeed unconventionally.”
Most of the Retail traders end up losing money in the market is because they enter at the stage of euphoria when the markets are over-heated and they tend to follow herd mentality and most commonly they watch news channels which confirm their thoughts.
Anchoring is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered when making decisions. Investors hold on to some information that may no longer be relevant, and make their decisions based on that. New information is labelled as incorrect or irrelevant and ignored in the decision making process. Investors who wait for the ‘right price’ to sell even when new information indicate that the expected price is no longer appropriate, are exhibiting this bias. For example, they may be holding on to losing stocks in expectation of the price regaining levels that are no longer viable given current information, and this impacts the overall portfolio returns. Actually, the decision should be made purely on the basis of what price and value difference exist today in light of available information rather than based on what the prices were in the past.
We project recent past to the distance future completely ignoring the distant past.
As Charlie says,
If we can avoid the above biases, we well might become masters of our mind and money.
Inspirations : Internet , Safaniveshak.com , NISM (Study material)