Behavioral Finance: Know your biases

Behavioral finance is an amalgamative strand of economics and psychology that advocates the cognitive biases which affect investment decisions. The human tendency to be influenced by emotion, circumstance, and short-term market volatility is inevitable, yet awareness of these biases can trigger individuals to make financially sound decisions and clearly define investment priorities, helping them in making more rational monetary choices.

Primarily, the theory of ‘Loss Aversion’ propounds that our negative response to losses is twice as much as our positive reaction to market gains. This partly explains the disposition effect: propensity to be risk seekers over losses and risk-averse over gains. This suggests that individuals are inclined to sell ‘winning investments’, in reluctance to take risks, since this could mean losing money. Additionally, they will hold onto the unprofitable assets and investments, clinging onto the hope of them to do better in the future, so that they can at least recoup the initial investment amount. In anticipation of realizing gains from investments that are currently falling in value, they tend to deviate from a near rational standpoint and may end up making a greater loss.

In correspondence with loss aversion, the idea of the ‘Endowment Effect’ highlights that people tend to overvalue the worth of stocks and financial items that they possess. This explains why they hold on to the assets with low market value. Investors want to see certain things from a fixed lens that complements their reperceived notions and beliefs. This complements the ideals of belief perseverance and confirmation bias. In some cases, people may misinterpret financial statements and information so that it appears to be in their favor. In addition, they are likely to underreact to certain data which is not in line with their beliefs (conservatism).

A prime factor in undiversified investment portfolios can be rooted in the principle of Herd Behavior, which is also known as the ‘Bandwagon Effect. This iterates the human desire to fit in. It intrudes on individualistic financial selections and evokes investors to ‘follow the crowd’. This influence can have adverse implications like ‘panic buying’ and ‘panic selling’. It may evoke an individual to react a certain way simply because others are doing it, even if the investor concerned is not convinced to do so. A recent example could be the IPO of Life Insurance Corporation of India. People subscribed to it despite knowing that it is being offered at a high valuation as it gave discounts to retail investors and policyholders. They fell into the temptation of being ‘among the masses’ and applied for the IPO to claim that discount. So even while people knew it was overvalued, they still went ahead and applied. Similar behavior was also perceptible during the initial offerings of Paytm and Zomato, where people applied solely because everyone else was doing so, despite knowing that the companies were making huge losses.

The aforementioned factors outline behavioral patterns which make people more prone to changes in the return on their investment and fluctuations in the marketplace. In various financial scenarios, people disregard long-term gains over short-term utility and pleasure. Investments require informed decision-making and analysis of market trends. The proclivity to fall into behavioral traps hinders this ability by seeping into distinct psychological frameworks. Realizing these biases and suppressing their influence becomes increasingly potent when considering financial decisions.