Behavioural Factors Limiting Rationality in the World of Finance
Mr. Shaleen Suneja
The author is Deputy Director, ICAI. He can be reached at ssuneja@icai.in and eboard@icai.in.
The Chartered Accountants with their acumen in the area of commercial matters display keen interest in the world of capital market, particularly stock markets. The education and training of Chartered Accountancy course has taught them complex tools and strategies to fundamentally analyze the inherent worth of assets and take crucial as well as beneficial financial decisions. Equipped with the knowledge of complex financial strategies they have abilities to proficiently render expert services to create rewarding portfolios. Even before making small value investments, the professionals will study past profits, volumes, growth, price-earnings ratio, promoters and like to judge the worth of assets.
It is important to note that the stock market efficiency causes existing share prices to always incorporate and reflect all relevant information thus stocks trade at their fair value. The participants in the markets are assumed to be fully rational in their approach.
However, in spite of all this many investors face heavy losses. There are occasions when stocks lose significant portion of their value in no time.
Market Volatility and Historical Downturns
On eighth of January, 2008, the Nifty reached intra-day all time high of 6357.1 points rising more than 500 per cent in the new millennium. Same year on 27th October, it fell to 2252.75 points, its nadir in the post crisis period. About 64 per cent of the value of Nifty was eroded in less than a year.
Again the markets plummeted after the threat on economy was evident after the lockdown in the early part of the year, 2020. The stock markets can be notoriously volatile. They can make paupers, king and kings, pauper. The question which then arises is why markets are so volatile. Where is the efficient market theory? We have also seen people who have made huge empire by investing in stocks. Many of us awe the strategies of Warren Buffet or Rakesh Jhunjhunwala, an ICAI alumni. There are people who will blindly buy stocks recommended by them.
Lately, there are numerous studies highlighting the importance of understanding the world of behavioural finance for the traders, investors, fund managers, analysts, and other financial professionals. In the world of behavioral finance, presence of circumstances is acknowledged which naturally makes the financial markets informationally inefficient. In this world, emotions rule and information from psychological factors have similar importance as information from final accounts.
Psychological Biases Present in Investors
Cognitive psychologists have documented different patterns regarding how people behave. Some of these patterns are heuristics, overconfidence, mental accounting, framing, conservatism, representativeness, disposition effect [Ritter, Jay R., 2003]. Let us see some of the psychological biases present among the traders and investors:
1. Overoptimism and Overconfidence
Investors are often found to be optimistic in nature as they feel that they are in control of things while in reality it is other way round. They exaggerate their own abilities to understand things and often harbour the dillusion that things are within their control. Such investors possess self-attribution bias as they attribute success to their own abilities and external factors or bad luck for unsuccessful outcomes.
Investors are not only optimistic, but also overconfident. They believe that the actions taken by them are right and they will provide them intended returns. An overconfident person overestimates his ability to successfully perform a particular task. All of us can recall how a classmate who lost in a debate competition blamed judges to be biased or blamed teachers for less marks. A good number of psychological researches indicate that people in general are overconfident. Overconfidence is also labeled as miscalibration as it a belief that one knows more than one actually does.
Combined together optimism and overconfidence can impel traders and investors to overrate their abilities to buy stocks and underrate the risks involved.
2. Heuristics
Heuristics, or rules of thumb, make decision-making easier. It is a strategy that can be applied to a variety of problems and can lead to correct solutions. Heuristics are the shortcuts to reduce complex problem solving to simpler judgmental operations. Despite what financial experts may assume, many investors do not calculate odds properly when taking investment decisions. They may assign mental subjective probabilities to various alternatives and take decisions. They make the task of decision making easier and simpler. Sometimes heuristics may lead to suboptimal investment decisions. Use of heuristics results in cognitive weaknesses in individuals’ decision-making, leading them to make inferior decisions with regard to their individual welfare. [Akinbami, Folarin. 2011]
Three popular heuristics that are applied are Representativeness, Availability, Anchoring and Adjustment [Tversky and Kahneman, 1974]:
Representativeness Heuristic
A person may estimate likelihood of an event by comparing it to a previous experience or an example that already exists in mind. Our thoughts are conditioned as per the most relevant or typical example of a particular event or object. Suppose if one associates men with long hair to be from entertainment and media industry, will relate any man with long hair with entertainment and media. Representativeness heuristic may lead investors to use their knowledge of one successful company as a stereotype for another similar company and accordingly judge both the companies at par and likely to be equally successful.
Availability Bias
Human thinking is highly influenced by things that are recently experienced, relevant or are dramatic in nature. It is information-processing bias where likelihood of an outcome is estimated on the basis of how easily the outcome comes to mind. An investor who has lost heavily by investing in shares is more likely to be vary of stock markets in future. However, over time, the person may return to his normal investing pattern.
Anchoring and Adjustments
Anchoring is an information-processing bias in some of the investors. A ship is anchored so that it does not move. Anchoring happens in investors because relative analysis and comparison seems easier as opposed to understand absolute figures. Investors influenced by this bias, often are fixed on a particular buy-price or sell-price target, even when the investing landscape poses new information. Such investors do not adequately adjust the anchor and therefore their forecast tends to be biased. Sometimes investors anchor themselves with previous high prices and buy stocks that have fallen considerably. While anchoring, far too much emphasis is made on a single piece of information, while ignoring other available information.
3. Loss Aversion
There are a number of academic researches suggesting that loss aversion plays an important role in the decisions taken by some of the investors. Loss aversion is the tendency of investors to be more sensitive to losses in comparison to gains. The context is often displayed in pricing decisions by many marketers. It is common for restaurants to offer off-peak hour discounts rather than having surcharges during rush hours. People are happy taking discounts rather than paying extra. As per the concept of loss aversion people experience greater pain in losing than the pleasure they have in getting similar gains.
4. The Disposition Effect
Consider example of an investor who buys a share and is happy to sell to make a gain of about 3 per cent in 7-8 days. It is a different story that the momentum took the stock to rise by another 20 per cent in about 3 months. However, another share bought by him fell, he patiently waited for it to revive. However to his dismay the value of this share halved in just two months. Somebody guided him to average out by putting in more money; convinced, he doubled the money put in the scrip. In next couple of months, it again lost another 30 per cent. It is a common mistake many investors make. They book profits too soon and stick to loss making scrips too long. They forget the concept of stop-loss. Here rationality is overshadowed by other psychological factors.
Disposition effect is the tendency to sell winners and hold losers. Individual investors have a strong preference for selling stocks that have increased in value relative to stocks that have decreased in value.
5. Narrow Framing
Narrow framing is the tendency of investors to focus on narrowly defined losses or gains. People while narrow-framing will take investment decisions without considering the impact on their total portfolio. The notion explains how people mentally evaluate risk while making investments and thus leads to conclude that the manner in which a concept is presented to individual has a bearing on the decisions. A narrow-framing investor may ignore the benefits that can be achieved through diversification. These people may be heavily invested in some of the individual stocks or industry, for example in pharmaceutical stocks that are in interest these days.
6. Herd Behaviour
Herd behavior is a phenomenon often seen in stock markets. You may recall the era prior to the financial crisis of 2008. During those times there was unprecedented interest in the stock market. Persons who were otherwise vary of stock markets were not only talking about the market but also making investments, however small they may be. At that time, people who were hardly investing were considering bidding in a particular IPO which was being fancied by many – even by taking a loan. These were clear signs that something was wrong. Money does not come easily, it has to be earned, hard way. During those days some of the IPOs were selling like hot cakes; getting responses as if they can make you millionaire overnight. Companies were also flocking to raise funds.
However, the euphoria did not last as the markets fell and investors took a turn to opposite direction. In 2007-8 there were 85 IPOs for 42,595 crores and in 2008-9 there were 21 IPOs amounting to 2,082 crores. The investors and fund managers, without appreciating the trade-off between risk and rewards, acted in herds. Herd behavior may lead to gradual formation of bubbles that may burst to crash.
RBI Warning on Asset Price Inflation & Bubble Risk
Recently, the Reserve Bank of India (RBI) has warned building of a bubble in the stock market as prices of risky assets surging to record high levels. The Reserve Bank of India has hinted that Indian equity markets are in a bubble, and that high valuations in the market are far from the ground realities. The Central Bank in its annual report 2020-21 stated that the magnitude of asset price inflation in the country poses the risk of a bubble as there is estimated 8% contraction in GDP in 2020-21. In fact, the benchmark Sensex has risen a whopping 100 per cent from the lows reached in March 2020 after pandemic induced lockdown.
Herd behaviour is not restricted to stock markets or humans. It is naturally witnessed in animal kingdom. It is found in humans and extends to different aspect of business. We can often observe sudden interests in information technology which shifts to real estate and then to some other sector.
The herd behavior may be rational or irrational. In fact herding is a natural instinct that is always present while taking decisions. It is a subconscious bias that is linked to human need to conform to things.
Herding may be intentional or spurious. Intentional herding results from obvious intent of investors to copy the behaviour of other investors. Spurious herding is an efficient outcome of groups taking similar decisions when provided with similar information. For example, a general rise in the interest rates may reduce the proportion of stocks in the portfolio of investors. (Bikhchandani and Sharma (2001)) Spurious herding is not a consequence of copying decisions of other investors, but merely a reaction to available information.
Endnote
The world of finance is highly complex and dynamic. In this article, a number of behavioural factors that limit the rationality aspects of investors and lead to sub-optimal decisions have been explained. The professionals may appreciate that the models of fundamental analysis based on the rationality may not produce the results that are exhibited in the real world. Knowledge of presence of behavioural factors will help investors avoid common pitfalls and take better decisions.
There is need to understand the presence of herd-behaviour and cognitive positions that investors may take. Equipped with this knowledge, they can take better decisions for themselves, clients or for their organisations.