Psychology of investing

Behavioural economics has attempted to better understand and explain how our emotions and cognitive errors influence our investment decision-making process.

The fundamental difference between classical finance and behavioural finance is that while the former is concerned with how people should behave, the latter has an empirical basis in that it is focused on how people have actually behaved in the real world, bringing together the fields of psychology and economics. Let us look at some of the key findings of behavioural economics.

Money isn't "fungible"

Richard Thaler, considered a pioneer of behavioural economics, coined the term "mental accounting", which refers to the inclination to categorise and treat money differently depending on where it comes from, where it is kept, and how it is spent.

In the minds of most people, the value of money varies with circumstances. For instance, people will go out of their way to achieve a saving of Rs.5 on the purchase of goods worth Rs.25, but won't go to the same trouble to save Rs.5 on the purchase of a CD worth Rs. 500.

Most people sort their money into accounts like ''current income'', "profits" and ''savings'' and justify different expenditures from each. One more finding related to this is that a rupee lost tends to be twice as painful compared to the pleasure of a rupee gained.

People are more concerned about the change in their wealth

In 1979, from the various experiments conducted for their "Prospect Theory", Amos Tversky and Daniel Kahneman (Nobel prize winner for Economics) found that people place different weights on gains and losses, and on ranges of probability.

They also believed that people respond differently to equivalent situations, depending upon whether it is presented in the context of losses or gains. Therefore, they concluded that people are willing to take more risks to avoid loss than to realise gains.

People tend to ignore "sunk costs"

A familiar problem with investments is called the sunk cost effect, otherwise known as "throwing good money after bad". It is also related to regret aversion and loss aversion.

While people are averse to taking risks when it comes to investing, their dislike of incurring losses is so great that many are willing to accept gambles in the hope of avoiding them.

Imagine that someone had bought shares of "XTech" before the tech bubble burst in 2000. The market price is now a lot lower than the price paid and the investor is sitting on a big paper loss. However, he/she is unlikely to sell the shares - because that would involve "crystallising" the loss.

However, as soon as the shares get back to the purchase price, the investor will start selling them off. Some investors might be willing to take a gamble on shares of other companies on a hot tip, so that they can make up for the loss. Now, as per classical economics, this is irrational thinking.

The past is irrelevant; all that matters is the future. And the key question about the future is: which investment offers the best prospects of gain? If the answer to that question isn't XTech shares, they should have been sold taking the loss and what's left of the investment being put into the best options available.

Humans are loath to admit they are wrong and realise a loss - even at the greater risk of holding a losing stock that could fall further in value.

We might convince ourselves instead that the stock will bounce back (pattern bias), or interpret news suggesting a bounce-back is likely (confirming bias). Or we might just hold the stock and blame others for the mistake.

The status-quo bias

One may not be willing to pay much for a particular item, but once they own it, they need to be offered a lot more before they are willing to sell it.

This is a bias towards preserving the status quo. A study conducted by William Samuelson and Richard Zeckhauser gives an insight into our reluctance to change when dealing with financial issues.

A group of students were asked how they would invest a hypothetical large inheritance. Half of them received their inheritance in low-risk bonds and the rest received higher-risk securities.

Common sense would suggest that individuals would reassess their asset allocation based on their risk profile and time frames, but both groups chose to leave most of their money alone.

The students' fear of switching into securities that might end up losing value could have prevented them from making the rational choice: rebalancing their portfolios.

Thaler and Tversky noticed a related bias called the endowment effect during their studies. This reflects the tendency of people to attribute a higher value to things that they own, in comparison to the price they would pay for buying the same things.

This effect was tested with coffee mugs imprinted with the Cornell University logo. The price at which students who were given the mug were willing to sell was much higher than the price students without the mugs were willing to pay. These two biases combined with loss aversion contribute to poor investment decisions.

Herding Instinct

Human beings are social creatures and draw comfort of being in a group and the majority's actions are taken to be good. History is replete with examples of bubbles created by the herding instinct, starting from the South Sea Bubble in the 1700s, Florida Land Boom in early 1920s and the recent technology bubble which burst in 2000.

During euphoric market conditions, investors normally lose sight of fundamentals and buy into any stock / sector which is seeing a strong upward momentum.

Also, attracted by the "irrational exuberance", investors tend to invest large sums of money in select sectors / stocks at one go, without paying heed to one's current asset allocation and risk tolerance levels.

This leads buying securities at high prices near the peak and also selling of securities at much lower prices during a downturn. These trends occur because investors tend to move in crowds .

Conclusion

As in life, success in investment depends on the decisions one makes and their outcome. In other words, keeping emotions out while investing.