BEHAVIOURAL FINANCE
"EMOTIONAL INVESTMENT" – THE WITS OF INVESTMENT


Author(s)
M. Subramanian
Faculty
Institute for Technology & Management, Chennai
Contact: financesubbuu@rediffmail.com
Cell No. 09443929922
Dr. A Venkatachalam
Reader
PG Commerce Dept, SVN College, Nagmalai, Madurai
Cell No. 09443092892


Introduction

The following finding from the famous "Prospect Theory" of Kahneman and Tversky has been a thought provoking issue with respect to this paper "Emotional Investment – The wits of investment" Two groups were asked about the following:

Group-1

In addition to whatever you own, you have been given Rs.1,000. You are now asked to choose between:
A. A sure gain of Rs.500
B. A 50% chance to gain Rs.1,000 and a 50% chance to gain nothing.

Group-2

In addition to whatever you own, you have been given Rs.2,000. You are now asked to choose between:
A. A sure loss of Rs.500
B. A 50% chance to lose Rs.1,000 and a 50% chance to lose nothing.

Result

In the first group 84% chose A. In the second group 69% chose B. The two problems are identical in terms of net cash to the subject, however the phrasing of the question causes the problems to be interpreted differently.

The word investment is prevailing in all walks of life. The reasons behind the investment vary from person to person depending upon their time & need. For example, if look at Warren Buffet's approach to investment is to search for fundamental values overlooked by the stock market. He has also followed an elementally simple rule: Never invest unless you can find something worth buying. The quintessential pragmatist, Buffet is interested only in realities and is free of any illusions, especially about himself. His influence on others' stock market behaviour has, therefore, been limited, since markets are driven to a significant degree by fear, greed and delusions. But his success has demonstrated that common sense and consistent rationality with the day even in irrational markets.

Then, what does the word investment means to an ordinary man?

A theoretical view with a perfect blend of real life gives the meaning of investment as the following equation:

Investment =
(Postponement of current consumption) +
{Commitment of funds} +
{For a future period} +
{In expectation of good rate of return} +
(With some degree of risk)

"Behavioural Finance" – what is this?

  • Much of economic and financial theory is based on the notion that individuals act rationally and consider all available information in the decision-making process.
  • However, researchers have uncovered a surprisingly large amount of evidence that this is frequently not the case.
  • Dozens of examples of irrational behavior and repeated errors in judgement have been documented in academic studies.
  • Peter L. Bernstein in Against The Gods states that the evidence "reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty."
  • A field known as "behavioral finance" has evolved that attempts to better understand and explain how emotions and cognitive errors influence investors and the decision-making process.
  • Many researchers believe that the study of psychology and other social sciences can shed considerable light on the efficiency of financial markets as well as explain many stock market anomalies, market bubbles, and crashes.
  • As an example, some believe that the out performance of value investing results from investor's irrational overconfidence in exciting growth companies and from the fact that investors generate pleasure and pride from owning growth stocks.
  • Many researchers (not all) believe that these human flaws are consistent, predictable, and can be exploited for profit.

Fact File (based on the study) - Emotional Investment – The Wits of Investment

Based on serious and sincere study on the emotional behavioural aspects of investors the following were found:

  • Investors place different weights on gains & losses and on different ranges of probability.
  • Investors are much more distressed by prospective losses than they are happy by equivalent gains.
  • Some investors consider the loss of Rs.1 twice as painful as the pleasure received from an Rs.1 gain.
  • Investors respond differently to equivalent situations depending on whether it is presented in the context of losses or gains.
  • Few investors are willing to take more risks to avoid losses than to realize gains.
  • Faced with sure gain, most investors are risk-averse, but faced with sure loss, investors become risk-takers.
  • In general individuals tend to feel sorrow and grief after having made an error in judgement. Typically, investors deciding whether to sell a security are emotionally affected by whether the security was bought for more or less than the current price.
  • One of the major finding from the study is that investors avoid selling stocks that have gone down in order to avoid the pain and regret of having made a bad investment.
  • Many amateur investors follow the crowd and conventional wisdom to avoid the possibility of feeling regret in the event that their decisions prove to be incorrect.
  • Many investors find it easier to buy a popular stock and rationalize it going down since everyone else owned it and thought so highly of it.
  • Buying a stock with a bad image is harder to rationalize if it goes down.
  • Additionally, many investors believe that mutual fund executives and advisors favour well-known and popular companies because they are less likely to be fired if they under perform.
  • Investors typically give too much weight to recent experience and extrapolate recent trends that are at odds with long-run averages and statistical odds.
  • Amateur investors tend to become more optimistic when the market goes up and more pessimistic when the market goes down.
  • Semi-professional investors believe that when high percentages of participants become overly optimistic or pessimistic about the future, it is a signal that the opposite scenario will occur.
  • Individuals are overconfident in their own abilities, and investors and analysts are particularly overconfident in areas where they have some knowledge.
  • However, increasing levels of confidence frequently show no correlation with greater success.
  • The study provides evidence that investors prefer local or familiar stocks even though there may be no rational reason to prefer the local stock over other comparable stocks that the investor is unfamiliar with.
  • Individuals often see other people's decisions as the result of disposition but they see their own choices as rational.
  • Investors frequently trade on information they believe to be superior and relevant, when in fact it is not and is fully discounted by the market.
  • This results in frequent trading and consistently high volumes in financial markets that many researchers find puzzling.
  • On one side of each speculative trade is a participant who believes he or she has superior information and on the other side is another participant who believes his/her information is superior. Yet they can't both be right.

HOW TO MAINTAIN EMOTIONAL BALANCE IN TERMS OF INVESTMENT DECISIONS?

      • Striking a right emotional balance between two extremes in terms of money matters (like investment) is really a challenging task.
      • To have a right emotional balance between the two extremes, follow the following steps:
        (a) Draw out a practical plan
        (b) Stick on to the plan, till you feel it is in your control
        (c) Have a practice of Yoga and practice it regularly. It is a good therapy for emotional balance at all times
        (d) Be patient and act smart

ACCEPT THAT INVESTING IS A PROBABILISTIC ART

      • Have a state of mind that investing is a probabilistic art.
      • Investing is not static; it is highly dynamic to the environment.
      • Investing is too sensitive; accept the feel of feather touch by the external environment.
      • Chances of happening of all events are equally distributed – with respect to investing.
      • Draw out a probability plan of your investment pattern and have a pucca monitoring system over it.

RECOGNIZE AND AVOID THE CIRCUMSTANCES LEADING TO UNDUE CONFIDENCE.

      • Avoid over confidence and over estimating your abilities.
      • Recognize and avoid the circumstances leading to undue confidence.
      • Many times over estimating your abilities are because of peers, friends and relatives boost you up at the times of your suggestions/views goes in the proper direction. But all the time your might not be correct.
      • Try to strike a proper balance of confidence in all times.

DELIBERATELY SEEK OUT THE CONTRARY VIEW.

      • Always try to have a contrary view, but in this kindly know your limits/boundaries.
      • All times the contrary view may not give desired results, keep an eye over you view.
      • Confirm the logic behind your view and hold.

AVOID LISTENING & ACTING TO GOSSIPS/RUMORS.

      • Please avoid listening & acting to gossips / rumors.
      • Many investors has lost money based on their action to those gossips.
      • Even though you hear from a reliable source, have second thought before acting to that information.

HAVE A WRITTEN PLAN FOR EACH POSITION, ESPECIALLY THE "IN & EXIT STRATEGIES"

      • Have a clear-cut written plan for each position, especially the in and exit strategies.
      • Written plans are not enough, but you should stick on to those plans accordingly.
      • Many a times even after planning it has gone wrong, because of improper execution.

CREATE FEEDBACK LOOPS THAT ALLOW FOR PROCESS ANALYSIS AND IMPROVEMENT.

      • Investors should create reliable feedback loops that allow for process analysis and improvement in their strategies.
      • If the feedback system is said to have any loopholes, you may not be able to take smart decisions.
      • Before you implement the feedback loops, have test session.

CONCLUSION

      • What ever be the suggestion and advice, it depends on the individuals how they react to the situation, that they face.
      • So it has become more important to be emotionally balanced in money matters.
      • Why should you waste your hard earned money, just to be washed away by your emotional investment decisions?
      • THINK… ACT… CONTROL YOUR EMOTIONS IN MONEY MATTERS… IT IS TOO HARD TO PRACTICE… BUT NO OTHER GO… TO PROTECT YOUR HARD EARNED MONEY… YOU HAVE TO BE PATIENT AND SMART ENOUGH WITH A PROPER STRIKE OF EMOTIONAL BALANCE.
         


Author(s)
M. Subramanian
Faculty
Institute for Technology & Management, Chennai
Contact: financesubbuu@rediffmail.com
Cell No. 09443929922
Dr. A Venkatachalam
Reader
PG Commerce Dept, SVN College, Nagmalai, Madurai
Cell No. 09443092892
 

Source : E-mail November 20, 2004

 

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