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| Edited By: Saravana Kumar |Source: DNA |Updated: Jan 19, 2018, 05:50 AM IST
Investor behaviour often deviates from logic and reason. We then focus on how behavioural biases, emotions, and systematic cognitive errors can affect investment decisions. We conclude with a few observations about how understanding investor behaviour can affect decision-making processes.
Euphoria and panic: If the intuitive mind dominates in making investment decisions, then investors risk damaging their wealth by buying at the top in a state of euphoria and greed and selling out at the bottom in blind panic.
The difference between the published return of a fund and the return an investor receives (which depends on when they enter and exit a fund) illustrates whether investors are good or bad at timing markets.
Following the crowd: Too many people buy when everybody else is buying, and sell when everybody sells. This means they repeatedly buy at the top of the market when the shares are expensive, and sell at the bottom when prices have tumbled. Herd mentality is a formula for losing money. If you're following the herd, you're probably getting in late on investments that could have been a good short-term purchase prior to being popular. If you see a financial trend and follow it, it probably means you're buying an already-inflated investment. A trend is a trend because demand has gone to that side of the market. Buying the trendy investment is, by definition, buying it at an inflated price point. Look for companies that are temporarily unloved, so you can buy their shares at a discount to their intrinsic value.
Stubbornly holding on to losing stocks: Without a logical set of pre-defined sell rules, investors often find themselves holding on to losing stocks for a long time. They usually "justify" their decisions by thinking that the price of the stock will rise eventually.
The problem with this approach is that by holding on to losing stocks for too long, the risk that the investor is assuming often rises to dangerously high levels. To make matters worse, when he finally decides to sell the stock, he will usually incur a loss that is much larger than intended.
Investing in top performers based solely on performance: Isn't investing in top performers always a good idea? Not necessarily.
This one is applicable to investors in market-linked avenues like mutual funds. When investments are made based solely on performance, an important evaluation parameter is overlooked – risk. And investing in line with one's risk appetite is a fundamental rule of investing.
Investors must try to understand the reason behind the impressive showing. This, in turn, will help them evaluate if the performance is sustainable.
Mirroring someone else's investments: While it's one thing to imitate someone else's lifestyle choices, using the same approach to investing in this manner can have disastrous results. Investing is a personalised activity.
Consequently, the investment avenues chosen have to be right for the investor. They should mirror his risk-taking ability and investment goals. What might be suited for one investor could be completely unsuitable for another. For instance, the investment portfolio of a retiree seeking assured monthly income cannot be the same as that of a risk-taking investor who intends to build a retirement kitty.
Although individuals cannot prevent all behavioural biases, investment professionals can advise clients how to reduce their influence during the investment process. This requires gaining an understanding of the clients' psychological biases, resisting the inclination to engage in such investor behaviours, and establishing and implementing disciplined investment strategies.
The writer is CIO, LIC Mutual Fund
