The role of Psychology in Equity investing

According to standard economic theory, investors are rational and take into account many considerations before making any financial decisions. However, while we’d all like to believe that buying or selling stocks is a rational decision, anyone who has invested will tell you otherwise. There are many forces that shape our investment making decisions.  

Investment Mindset:

In a research study conducted by Dalbar, a financial services market research firm, in 2001 entitled 'Quantitative Analysis of Investor Behaviour', which concluded that average investors consistently failed to achieve returns, beat, or even match the broader market indices. The study found that in the 17-year period to December 2000, S&P 500 returned an average of 16.29 per cent per year, while a typical equity investor achieved only 5.32 per cent during the same period, a startling 9 per cent difference! Why did this happen? Behavioural finance provides some possible explanations: 

1) Fear of regret: Fear of regret, or simply regret theory, deals with the emotional reaction that people experience after realising they've made an error in judgement. Faced with the prospect of selling a stock, investors become emotionally affected by the price, at which, they purchase the stock. So, they avoid selling it as a way to avoid the regret of having made a bad investment as well as the embarrassment of reporting a loss. We all hate to be wrong, don't we? 

2) Mental accounting behaviour: Humans have a tendency to place particular events into mental compartments, and the difference between these compartments sometimes impacts our behaviour more than the events themselves. An investing example of mental accounting is best illustrated by the hesitation to sell an investment that once had monstrous gains and now, has a modest gain. During an economic boom and bull market, people get accustomed to healthy, albeit paper gains. When the market correction deflates investors' net worth, they're more hesitant to sell at a smaller profit margin. They create mental compartments for the gains they once had, causing them to wait for the return of that profitable period. 

3) Prospect theory: It doesn't take a neurosurgeon to know that people prefer a sure investment return to an uncertain one. We want to get paid for taking on any extra risk, which is pretty reasonable. Here's the strange part. Prospect theory suggests that people express a different degree of emotion towards gains than losses. Individuals are more stressed by prospective losses than they are happy from equal gains. 

4) Loss aversion: The loss-aversion theory points to another reason why investors might choose to hold their losers and sell their winners. They may believe that today's losers may soon outperform today's winners. Investors often make the mistake of chasing market action by investing in stocks or funds, which garner the most attention. Research shows that money flows into high-performance mutual funds more rapidly than from funds that are underperforming. 

5) Anchoring behaviour: In the absence of better or new information, investors often assume that the market price is the correct price. People tend to place too much credence on recent market views, opinions & events and mistakenly, extrapolate recent trends that differ from historical, long-term averages as well as probabilities. 

6) Over & under-reacting: Investors get optimistic when the market goes up, assuming that it will continue to do so. Conversely, investors become extremely pessimistic during downturns. A consequence of anchoring or placing too much importance on recent events while ignoring historical data is an over or under-reaction to market events, which result in prices falling too much on bad news and rising too much on good news. 

An investor has to overcome all this biases for being successful in equity investment. 

---