Importance Of Investor Behaviour In Investing

Stuck in traffic, all of us have seen how different vehicles move about. Some two-wheeler drivers take advantage of even the narrowest spaces, often between cars and buses, to press ahead.
They risk not only their own but the safety of others too. And at times all this for a mere 5-10 metre advantage, which ends at the edge of the zebra crossing where the lights are anyways red. They see opportunity when there isn't. Some car drivers keep honking, disturbing others at a time when most are helplessly at the mercy of the traffic lights. Only a few play it cool and patiently wait for the traffic to move.

Investors’ behaviour is similar in investing. During periods when assets perform well, investors behave in a particular fashion. When a downturn, however temporary sets in, investors are in a quandary. Investor behaviour can boost the return, but investor behaviour can also mar it. Behaviour gap is equal to investment return minus investor return. Let us find out why.

Irrational Decisions
If you ask an investor whether they would like to a) buy low, sell high or b) buy high, sell low, 100% of investors would choose the first option. This is rational thinking at play. However, when it comes to practices, even the otherwise rational decision makers can display irrational decisions. This can be due to a misperceived or misunderstood context of things. An irrational decision is something that goes against logic. Such a decision can be to sell an investment even when the goal is far from being achieved. It can be to buy an investment when everybody around you tells you about the bad factors about such a move. In a nutshell, irrational decisions are counter-productive.

Additionally, biases can cause investors to highlight information or disregard information. Biases can lead to too strong an attachment to an idea. Biases can also lead to an inability to recognise an opportunity. As investing became sophisticated, a huge amount of research has been done in the field of behavioural finance. The import of all such learning is simple: investors need to recognise behaviours and habits of their mind that act as stumbling block to objective decision making. Once you know the behaviour and habit, you can overcome them.

Biases
One kind of investor behaviour that leads to unexpected decisions is bias. What is a bias? A bias is a tendency to act in a set way that stifles objective thinking and objective decision making. Biases affect investment decisions. Let us look at a few of the biases to understand more about investing behaviour. For instance, availability bias occurs because investors rely on information to make informed decisions, but not all information is readily available. Stocks of corporations that get good media attention, for example, claim to do better than less publicised peers, when in reality the high-profile companies may actually have worse earnings and return potential.

Then there is representativeness bias. Here decision making is based on stereotypes. In investing, representativeness is a tendency to be more optimistic about investments that have performed well lately and more pessimistic about investments that have performed poorly. This is antithesis to the ‘buy low, sell high’ philosophy. If in your mind you stereotype the immediate past performance of investments as strong or weak, such a representation will make it really hard to think of them in a way that truthfully analyzes their potential. As a result, one may put too much emphasis on past performance and not enough on future prospects.

Bad Apple Syndrome
You may be familiar with the saying, ‘one bad apple can spoil the bunch’. That popular phrase is used to refer to a situation in which one person's negative behaviour can affect a whole group of people. The syndrome causes even persons with otherwise good behaviour to have a similar negative attitude or to engage in the same bad behaviour. The investment behaviour of certain investors can affect investment or fund performance and thus returns to other investors.

This type of investor externality causes harm to not just the investor, but to others as well. Mutual funds, a long-term investment vehicle, provide liquidity to investors at little direct cost. Unfortunately, some investors tend to trade more than others. Such trading can affect other investor clientele of an open-ended fund. Despite the mandate and investment objective of the investment vehicle being homogenous, sub-optimal investment behaviour of a certain type of individuals cause harm to others.

Conclusion
All investors like to think they invest rationally, but the field of behavioural finance has shown there are social, emotional and even cognitive factors that can affect investing decisions. Those factors can undermine an investor’s decision-making ability and impact long-term success. Thus, it is extremely important for investors to practice good investing behaviour, so that behaviour gap is reduced to minimal and investment return equals investor return.