Friday, July 01, 2011

What Is Behavioral Finance ?

Behavioral Finance’ is a discipline that studies the effects of emotions on people’s investment choices (particularly in the stock market).

behavioral-financeIt uses psychology based theories to explain how investors’ emotions and mental errors can cause stocks and bonds to be overvalued or undervalued.

Smart investors can make behavioral finance to work to their advantage.

 Investor Psychology And Behavioral Finance

Here are some of the concepts of behavioral finance:
OverConfident:Investors overestimate their stock picking abilities.

This leads to excessive trading (because they tend to believe they are better than the others and hence can beat the market). They do not practice the ‘buy and hold’ strategy. Also the overconfidence makes the investors believe that their losses are due to bad luck. This will prevent them from learning from past mistakes.

 Herd Like Behavior: Individuals follow the actions of a larger group (whether rational or irrational). The reasons for this herd like behavior are:
  • Conformity – Conforming with the crowd is easier than going against the crowd. And hence most of us prefer to conform.
  • The rationale that so many people can’t be wrong and so it is safer to be follow
This herd like behavior explains the booms and the busts we have witnessed in the past.

Our Attitude Towards Gain And Loss:

People feel the pain of loss much more than they derive pleasure from an equal gain. People are basically willing to take more risks to avoid losses than to realize gains. They prefer selling good performing stocks to book a profit rather than selling poor performers to cut losses. Theoretically investors should be holding on to good performing stocks so that they can increase their profits and sell the badly performing ones so that they can reduce their losses.

This thinking leads most investors to hold on to badly performing stocks, with the hope that it will perform better (and it might never do).

Anchoring: Here are a couple of examples to show how Anchoring affects investors:
1. Investors refuse to buy a stock today because it had a much lower price last year (in the past)
2. Investors refuse to sell a stock because it was much higher in the past.
Anchoring can lead to undervaluing or overvaluing a stock. Our brain uses historical perceptions and past data to value the stock. Assume a stock was priced at $10 last year…This year the company suffered a significant market share and hence the price fell to $5. Anchoring can lead investors to stick to past data which will lead them to believe that this stock is undervalued (because last year it was $10 and now only $5).

Over and Under Reaction:Investors tend to give too much importance to the recent news rather than looking at the whole big picture.
Lessons From Behavioral Finance
1. Be patient
2. Don’t trade excessively
3. Exercise ‘Buy and Hold’ approach
4. Learn from past mistakes
5. Don’t panic
6. Erase historical prices from your mind – have an open mind
7. Use a value based investment approach to stocks
8. And here is the big one – Don’t be tempted to follow the herd
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