12.3 Understanding investor behaviour
IT IS IMPORTANT TO UNDERSTAND INVESTOR BEHAVIOR
When it comes to money and investing, we are not always as rational as we think we are. Let us discuss the insights into the theory and findings of behavior finance. Look at this fact: Average investors fail to achieve market or normal stock index returns. In a study entitled 'Quantitative Analysis of Investor Behavior' (2001 Dalbar), in the last 17 years up to December 2000, the US stock index S&P 500 returned an average of 16.29 per cent per year. While most equity investors achieved only 5.32 per cent for the same period, the long-term government bond index reaped 11.83 per cent. Why does this happen? There are a many possible explanations. In an ideal scenario, investors would buy and sell investments without emotion. Unfortunately, research has shown that investors do not make decisions in a vacuum. Feelings of loss, pride, and regret can cloud the investment decision process. Investors may make better decisions by trying to understand the behavioral factors that can influence their judgment.
The 'fear of regret or simply regret' theory deals with the emotional reaction people experience after realizing they have made an error in judgment. Faced with the prospect of selling a stock, investors become emotionally affected by the price at which they purchased 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? What investors should really ask of themselves when contemplating selling a stock is: "What are the consequences of repeating the same purchase if this security was already sold and would I invest in it again?" If the answer is "no", it's time to sell. Otherwise, the result is regret of buying a losing stock and the regret of not selling when it became clear that a poor investment decision was made. Some investors avoid the possibility of feeling this regret by following the conventional wisdom and buying only stocks that everyone else is buying. Oddly enough, many people feel much less embarrassed about losing money on a popular stock that half the world owns - like Reliance or Infosys - than about losing on an unknown or unpopular stock.
Humans have a tendency to place particular events into mental compartments, and the difference between these compartments sometimes impacts our behavior more than the events themselves. An 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, in other words, paper gains. When the market correction deflates the investors' net worth, they are more hesitant to sell at the smaller profit margin. They create mental compartments for the gains they once had, causing them to wait for the return of that gainful period.
Imagine this: Mahesh bought XYZ shares during the market boom, say for Rs100. Now, during the market boom, it rises to Rs500. When it is sliding back, suppose at Rs.150, will it be easy for Mahesh to sell at this point? The answer is that for most people it is difficult because of our mental comparison of the earlier potential profit of Rs400 and the current profit of Rs50.
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 any extra risk. That's pretty reasonable. Here's the strange part though. The Prospect Theory suggests that people express a different degree of emotion towards gains than towards losses. Individuals are more stressed by prospective losses than they are happy from equal gains. For example, an investment advisor won’t necessarily get flooded with calls from her client when she's reported, say, gain of Rs50,000 in the client's portfolio. But, you can bet that phone will ring when it posts loss of Rs50,000.
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 in recent market views, opinions and events, and mistakenly extrapolate recent trends that differ from historical, long-term averages and probabilities. In bull markets, investment decisions are often influenced by price anchors and prices deemed significant because of their closeness to recent prices. This makes the more distant returns of the past irrelevant in investors’ decisions. For example, though the periodical corrections in the stock markets happened earlier, even when the BSE index touched the 21,000 levels, people felt that the only direction the index could go was up, and they kept piling more money in it. Investors anchored themselves to the recent performance without taking into account the true historical returns.
Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic amid downturns. A consequence of anchoring and placing too much importance on recent events while ignoring historical data is an over or under reaction to market events which results in prices falling too much on bad news and rising too much on good news. At the peak of optimism, investor greed moves stocks beyond their intrinsic value. We know people who invested on a growth stock at 8,000 market index during 2007 and it crossed above 20,000. Some of the shares yielded 2.5 times’ appreciation. Still they held on to the stocks, and it came back to that same level in 2008. So it was an overreaction to the growth pattern of the stock market imagining that it has only one way to go - up, up and up.
If an investor's previous investment plan was a success in the recent past, he or she starts buying or selling aggressively in any market (bullish or bearish). The investors also overestimate the precision of their knowledge and their knowledge relative to others. Many investors believe they can consistently time the market. But in reality, there’s an overwhelming amount of evidence that proves otherwise. This results in excess trades, with trading costs denting profits.