If you’re starting out in the investment game or have even been in it for a while, we guarantee you this is a MUST read. Behavioral finance is an emerging field and crosses finance with psychology. If you’ve ever bought shares, by the end of this article I’m sure you’ll find at least one of the concepts we are about to cover will have applied to you.
When talking the behavior of investors, there are two categories we can look at: individual investing and group investing (or looking at the markets as a whole and how they move) (Jaiswal, B., and Kamil, N, 2012). It has also been suggested there are differences between men and women when investing. Don’t worry, we’ll be covering all bases here to equip you with maximum knowledge.
Let’s begin by looking at some theories and applications.
Prospect Theory: Developed by Kahneman and Tversky, this theory suggests that after a stock price increases, investors tend to become less risky in their decisions and vice versa if a stock price decreases. In other words, investors will place different values on gains and losses even if it involves the same stock. For example, you read two different recommendations given by a financial analyst on the same stock. One of them will issue a strong buy recommendation telling you the stock has managed to return 5% over the past 3 years. However, the other analyst gives you a speculative buy recommendation stating that the stock has done extremely well over the past 5 years but is currently experiencing a decline. On the bases of Prospect Theory, you’ll go with the strong buy recommendation.
Disposition Effect: Developed by Shefrin and Statman, the disposition effect explains how investors may postpone feelings of regret by holding onto assets that are losing them money, whilst selling assets that are increasing in price.
Self-Attribution Bias: Investors tend to define their success as a result of their own individual skills however, when failure arises, they will blame it on an external event or party, or simply just bad luck.
Overconfidence: This theory was best described by Griffin and Tversky as a “phenomenon in which an individual overestimates the probability of his favoured hypothesis”.
Herd Behavior: Basically, this theory ascribes investor behavior to following the herd where investors tend to replicate decisions or portfolios of other investors or analysts rather than using their own individual judgment. This has been found especially to be the case when investing in small cap stocks (Wermers, 1999).
Cognitive Dissonance: This means there are inconsistencies in the thought process but, when related to finance, investors may put up a self-defence mechanism to protect themselves from new information that may in turn prove their assumptions or decisions to be incorrect. Ignorance is bliss right? Not in the case of the stock market. This theory contemplates that investors will hold onto their beliefs and decisions for far too long while searching for information that upholds and confirms their decisions, leading them to possibly then misinterpret information if it goes against their speculation.
Over-Reaction: This is when investors tend to overreact to market information. I have been guilty of this one unfortunately. Coming back to basic financial principles and market efficiency, new information ‘should’ be immediately reflected in a stock’s price. For example, if there’s good news, the company’s price is probably going to increase and vice versa. However, what often occurs is when investors overreact to this kind of information, it has a much larger and over-exaggerated effect on the price. So, if you buy a stock that has shot up a few dollars, be careful because, this may be the result of market overreaction and will therefore, slowly drop back to its true value.
Myopic Loss Aversion: if you suffer from this phenomenon, you probably take a short-term perspective on investments and are thoroughly preoccupied by any downward turn or loss of stock as opposed to any realized gains you may be experiencing. Volatility is totally normal and you’ll realize how volatile a stock can be in a day if you watch the markets like a hawk. However, suffering from myopic loss aversion, you probably react negatively to any decrease in price and thus affecting your short-term decision-making and your long-term capital gains.
Narrow Framing: Myopic loss aversion is linked with narrow framing in that investments are then looked at individually out of context. For example, say your current portfolio consists of a few health stocks already. However, you have just discovered a new company in the health industry that looks pretty good and you’re thinking of buying. Before you consider this option, you need to consider the diversification this company could give you in the context of your portfolio, as opposed to isolating this company without thinking of other alternatives that will aid you in diversifying more.
Alright, now that we’ve outlined a few theories behind the investing decisions you’re making, let’s quickly touch on gender (and yes, apparently there are differences between men and women when it comes to investing). According to Davar & Gill (2007), women possess a lower level of awareness, risk tolerance, confidence, are process driven and trade more cautiously. They are more likely to invest their money with the intent on receiving income as opposed to investing in growth stocks. Men however, have been found to be very focused on results, single minded and possess a higher risk tolerance sometimes leading to overconfidence. (Just a few fun facts for you boys and girls). So, what is the solution to this? It has been suggested financial analysis should look at tailoring portfolios making gender-specific behavioral adjustments – possible? Yes! Easy? Far from it.
Ok, I’m going to leave it there for now. Next week, AJ will release part 2 of this chapter in investing so be sure to subscribe to receive our updates! We hope this topic interests you as much as it interests us as there really are so many drivers behind the stock market and human behavior is a massive one!
We want to ask you though, have you experienced or are experiencing any of the psychological theories we’ve mentioned here? If so, we’d love to hear from you! Leave your comments below and tell us your story and how it has influenced your investments!
Jaiswal, B., and Kamil, N. (2012) ‘Gender, Behavioral Finance and the Investment Decision’. IBA Business Review, 7 (2), 8-22.
Shankar, D., and Dhankar, R. (2015) ‘Understanding the Behavior of Stock Market Functionality: Need and Role of Behavioral Finance.’ Review of Management, 5 (3/4), 5-11.
Davar. Y., and Gill. S (2007) ‘Investment Decision Making: An Exploration of the Role of Gender’. Decision, 34 (1).