How Investment Behavior Affects Stock Markets?

Behavioral finance is bound to exist as it is tied up with human psychology of inferring the same situations differently. All humans looking at a similar situation will infer different conclusions, which give rise to either inefficiencies or opportunities.

For eg- When people see a lot of money being made in the markets, then more people jump into it. And because of this, these people invest after prices have already gone up and thus end up selling when prices are down. This irrational behavior causes inefficiencies in the market.

Importance of Behavioural Finance:

Most investors make trading decisions based on emotions and logic. These types of investors buy high on speculation and then sell at low in panic thus making a loss. The main reason for this is that investors sell after the price of the stock has fallen a lot and then buy the stock when the price has increased a lot and they eventually start making losses. Behavioral finance helps us in understanding this kind of behavior of the investors. Understanding Behavioural Finance helps us to avoid emotion-driven speculation resulting in losses, and thus help us in devising an appropriate wealth management strategy.

Investor Overconfidence

People generally rate themselves as being above average in their abilities. They also overestimate the precision of their knowledge and their knowledge relative to others.

Many investors believe they’ll consistently time the market, but in point of fact, there’s an awesome amount of evidence that proves otherwise. Overconfidence leads to excess trades, with trading costs denting profits.

Investor Regret Theory

Fear of regret, or just regret theory, deals with the emotional reaction people experience after realizing they’ve made a slip in judgment. Faced with the prospect of selling a stock, investors become emotionally full of the worth at which they purchased the stock. So, they avoid selling it as some way to avoid the regret of getting made a nasty investment, also, because of the embarrassment of reporting a loss. Regret theory may also hold for investors after they discover that a stock they’d only considered buying has increased in value. Some investors avoid the likelihood of feeling this regret by following the traditional wisdom and buying only stocks that everybody else is buying, rationalizing their decision with “everyone else

Oddly enough, many people feel much less embarrassed about losing money on a popular stock that half the world owns than about losing money on an unknown or unpopular stock.

Mental Accounting Behaviors

Humans incline to position particular events into mental compartments, and also the difference between these compartments sometimes impacts our behavior quite the events themselves.

An investing example of mental accounting is best illustrated by the hesitation to sell an investment that when had monstrous gains and now incorporates a modest gain. During an economic boom and securities industry, people get aware of healthy, albeit paper, gains. When the market correction deflates investor’s net worth, they’re more hesitant to sell at the smaller ratio. They create mental compartments for the gains they once had, causing them to attend for the return of that profitable period.

Over — and Under-Reacting

Investors get optimistic when the market goes up, assuming it’ll still do so. Conversely, investors become extremely pessimistic during downturns. A consequence of anchoring, or placing an excessive amount of importance on recent events while ignoring historical data, is an over- or under-reaction to promote events, which ends up in prices falling an excessive amount of on bad news and rising an excessive amount of on excellent news.

At the height of optimism, investor greed moves stocks beyond their intrinsic values. When did it become a rational decision to speculate available with zero earnings and thus an infinite price-to-earnings (P/E) ratio (think dotcom era, circa the year 2000)?

Extreme cases of over- or under-reaction to promote events may result in market panics and crashes.

Prospect — and Loss-Aversion

It doesn’t take a neurosurgeon to understand that individuals prefer a sure investment return to an uncertain one — we want to urge obtained taking up any extra risk. That’s pretty reasonable.

Prospect theory also explains why investors hold onto losing stocks: people often take more risks to avoid losses than to appreciate gains. For this reason, investors willingly remain in an exceedingly risky stock position, hoping the value will improve. Gamblers on a run will behave in an exceedingly similar fashion, doubling up bets in an exceedingly bid to recoup what’s already been lost.

So, despite our rational desire to urge a return for the risks we take, we tend to value something we own beyond the value we’d normally be prepared to acquire it.

The loss-aversion theory points to a different reason why investors might like better to hold their losers and sell their winners: they’ll believe that today’s losers may soon outperform today’s winners. Investors often make the error of chasing market action by investing in stocks or funds which garner the foremost attention. Research shows that money flows into high-performance mutual funds faster than money flows out from underperforming funds.

Investor Anchoring Behavior

In the absence of higher or new information, investors often assume that the market value is the correct price. People tend to position an excessive amount of 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, which are prices deemed significant thanks to their closeness to recent prices. This makes them more distant returns of the past irrelevant in investors’ decisions.

These are some of the behaviors of investors that could likely affect the stock market.

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Author - Mayank Choudhary