Understanding the Psychology of Investing in Financial Markets


By

Gangineni Dhananjhay
Asst. Professor-Finance
MBA Department
Vivekananda School of P.G. Studies
Srinagar Colony, Punjagutta, Hyderabad-500 073
 


Abstract / Summary

Great investors and legendary traders are known for their mastery of trading psychology. These market wizards trade against market participants' psychological biases. Understanding these psychological aspects of risk bearing in financial markets will give an edge to market participants. Financial markets surprise and continue to surprise majority of traders and investors. There are countless approaches to trading in financial markets. George Soros speaks of reflexivity theory, Victor Niederhoffer on Scientific Method or Nassim Nicholas Taleb's Randomness.

As the trader progresses in his journey towards understanding the psychological fabric of markets, he will encounter various psychological biases. This article summarises and tries to capture some of these irrational components of risk taking behaviour. Awareness of these self-destructive biases is the only hedge possible in the financial markets.

The Psychology of Investing in Financial Markets:

You have to be able to control yourself. You can't  let emotions get in the way of your mind.
                                                                                                                      - Warren Buffet

Introduction:

Markets are assumed to be characterised by rational individual behaviour, with investors balancing risks and returns. When investors are rational they value each security for its fundamental value i.e. the net present value of its future cash flows discounted using their risk characteristics. But in practice it is difficult to sustain the case that people in general, and investors in particular are fully rational. Many investors react to irrelevant information in forming their demand for securities. As Fisher Black put it, they trade on noise rather than on information. Investors follow the advice of financial gurus, fail to diversify, actively trade stocks and churn their portfolios, sell winning stocks and hold on to losing stocks, follow stock price patterns and other popular models. This paper tries to capture some of the subjective elements of investors' decision making and psychology in the face of risk. Understanding these psychological aspects of risk enhances the investor's tenacity in an ever changing market scenario.

1. ANCHORING: Over relying on first thoughts.

The human brain gives more weight to the first information it receives. Initial impressions, ideas, estimates or data "anchor" subsequent thoughts. Anchors take many guises. They can be as simple and seemingly innocuous as comment offered by your spouse or a statistic appearing in the morning newspaper. Anchors often prejudice our thinking in ways that prevent us from making good decisions. Anchors are often used by savvy negotiators as a bargaining tactic. For example, you visit a local art dealer and seen on display is a unique and compelling painting by an unknown young artist a work that has no clear market value. You estimate its worth at approximately Rs. 12,000. when you begin talking about the painting with the dealer, he immediately suggests a price of Rs. 40,000. As an opening gambit, that price may be designed to anchor you, to shift your sense of the piece's worth upward, If you respond by attempting to bargain down from Rs. 40,000 the final cost may be unduly influenced by the dealer's initial proposal the anchor.

In Stock Market, investors compare the recently known past with a given market situation or price to draw broad conclusions. In this process more distant history loses relevance. A consequence of anchoring is under or over reaction. Impact of good or bad news becomes exaggerated. May be this explains optimistic and pessimistic market moods, generating euphoria or despair.

2. THE STATUS QUO: Keeping on keeping on

You inherit 100 shares of a blue chip stock that you would never have bought your self. (For example Reliance, Again Anchoring!) You can sell the shares as they have appreciated considerably. What will you do?

When faced with this situation, a surprising number of people hold on to the inherited shares. They find the status quo comfortable and they avoid taking action that would upset it. Many Psychological experiments have shown the magnetic attraction of status quo. In one, a group of people were randomly given one of  two gifts half received a decorated mug, the other half a large Swiss chocolate bar. They were then told they could effortlessly exchange the gift they received for the other gift. You might expect that about half would have wanted to make the exchange, but only one in ten actually did. The status quo exerted its power even though it had been arbitrarily established only minutes before.

3. SUNK COST: Protecting Earlier Choices

We tend to make choices in a way that justifies past choice. We may have refused to sell a stock or mutual fund at loss, losing other more attractive investments. We may have put enormous efforts into improving the performance of an employee whom we know we should not have hired in the first place. Your decision influences only the future, not the past. Investors are unwilling, consciously or not, to admit to a mistake. Investors are adverse to making public admission of poor judgement. It relates to not only the person's self esteem, but it may invite critical comments or negative assessments from friends, family members, colleagues, or bosses. It seems psychologically safer to hang on to a bad decision, even though it will compound the error.

4. CONFIRMING EVIDENCE: Seeing what you want to see

Suppose the stock market has gone too high and you've decided to sell most of your portfolio and invest the cash in a bank deposit. But before you call your broker, you decide to do one more thing to check the wisdom of selling. You call a friend, who you know sold out his portfolio last week, to find out her reasoning. He presents a strong case for a definite market decline. What do you do?

You may not let that conversation be the final point, because you've probably just fallen into the confirming evidence trap. This trap leads us to seek out information that supports our existing instinct or point of view while avoiding information that contradicts it. The confirming evidence trap not only affects where we go to collect evidence, but also how we interpret the evidence we do receive, leading us to give too much weight to supporting information and too little to conflicting information. Suppose you had read an article on the stock market advising people to sell in an investment magazine, for example you would have tended to be less critical of arguments in favour of selling stock and more critical of arguments in favour of remaining in the market.

There are two fundamental psychological forces at work here. First is our tendency to subconsciously decide what we want to do before we figure out why we want to do it. Second is our tendency to be more engaged by things we like than by things we dislike. Naturally, then we are drawn to information that confirms our subconscious leanings.

5. FRAMING: Posing the wrong question

Imagine that you are richer by Rs. 2 lakh . Suppose you get two options a). Receive Rs. 50,000 or b). A 50% chance to win Rs. 1 lakh and a 50% chance to win nothing.

Now imagine that you are richer by Rs. 3 lakh and you are compelled to choose between one of two options: c) Lose Rs. 50,000 or d) A 50% chance to lose Rs, 1 lakh and a 50% chance to lose nothing. You  probably end up choosing the something in the first question and gamble in the second,

What propelled you to do that? In both problems there is a choice between being Rs. 2.5 lakh richer than today or taking a 50:50 gamble in which you could end up richer by either Rs. 2 lakh or Rs. 3 lakh ( an expected return of Rs. 2.5 lakh), Although your answers to both questions should, rationally speaking, be the same, studies have shown that many people would refuse the 50-50 chance in the first question but accept in the second.

6. OVER CONFIDENCE: Being too sure of yourself

What's your forecast for BSE sensex one-month from today? How sure are you about your estimate? Now predict a high value such that you are 99% sure that Actual sensex value will be lower than that value. Next pick a low value such that you are 99% sure that the sensex will be higher than that value after a month. This gives a range such that there is a 98% chance that actual sensex value will fall between your low and high figure. If you make many, many estimates of this sort and your self appraisal of your estimating skills is good, statistically you should expect that only about 2% of the time would the actual value fall outside your assessed ranges. But experiments show that the actual value falls outside the range 20% to 30% of the time, not 2%. The beliefs of most investors are biased in the direction of optimism. Over confidence and optimism can cause you to over estimate your knowledge and under estimate risks.

7. RECALLABILITY: Focusing on Dramatic Events

What's the probability of a randomly selected jet flight on a major U.S. airline ending in a fatal crash?

What's your answer? If you're like most people, you will have overestimated the probability. The actual chance of such a crash? According to statistics, provided by researches at MIT, it is only about one in 10,000,000!.

We can be overly influenced by dramatic events. we exaggerate the probability of rare but catastrophic occurrences such as plane crashes. Because they get disproportionate attention in the media. A dramatic or traumatic event in your own life can also distort your thinking. You will assign a higher probability to traffic accidents if you've passed one on the way to work. You will assign a higher chance to someone's dying of Cancer if a close family member or friend has died of the disease.

Investors who have lost money in a bear market or severe market declines will not believe in the market and tend to have distorted views. Small investors did not believe in the strength of the market till BSE Sensex reached 5000 levels. This is because of investors burning their hands after the collapse of markets after tech boom in the year 2000.

8. OUT GUESSING RANDOMNESS: Seeing patterns where none exist

Human mind tries to see patterns in random phenomena. Despite our desire to see patterns, random phenomena remain just that, random. Dice and lotteries have neither memory nor conscience every roll, every number choice is a new different event, uninfluenced by all previous events.

Many investors unrealistically believe that they have a rare gift because the stock market provides an exceptionally fertile environment for self deception. Participants in the market can easily live in a world of make believe by accepting confirming evidence and rejecting contradictory evidence. As David Dreman says:

"Under conditions of anxiety and uncertainty, with a vast interacting information grid, the market can become a giant Rorschach test, allowing the investor to see any pattern that he wishes, experts cannot only analyse information incorrectly, they can also find relationships that aren't there a phenomenon called illusions correlation".

9. SURPRISE BY SURPRISES: Going mystical about coincidences

John is a legend. On two separate occasions he has won one in a million lottery. The chance of that happening is so rare 1 in 1 trillion that some people attribute it to divine intervention. Many people think themselves truly gifted because they've won a succession of bets (or made a series of successful investments).

Can we judge the success of people by their raw performance and their personal wealth? Some times but not always. A large section of businessmen with outstanding track records will be no better than randomly thrown darts. They may become wealthy because of sheer luck. Some unfortunates may not be losers because of their stupidity they may just be the unlucky ones. However, successful people fail to make an allowance for role of luck in their performance.

People just don't think very clearly when it comes to coincidence. They can't accept the indifference of randomness. They feel that they personally must have some special importance and impact on the great impersonal universe. They become mystical in their own reasoning and suspicious of the probabilistic reasoning of others.

CONCLUSION:

The world presents may potential surprises. You're bound to experience some of them. More so in financial markets which surprises most of the people most of the time. Investors must be prepared for the rare event however less probability it has. Some events that appear rare really aren't. what's the probability for example, that you'll find a pair of people with same birthday (day and month) out of 24 randomly chosen people? The answer is more than 50%. Traders after making series of profits, get wiped out. We have seen this in the case of Barings Bank. LTCM and many others.

Risk is the basic cornerstone of any financial market. In risk taking investors suffer form various biases. As the investment  process itself is a fight against one's own emotions, no body can save investor from himself. Awareness of these self destructive biases is the only hedge possible in the financial markets.

References:

1. S. Hammond, Ralph L. Keeney, Howard Raiffa: "Smart Choices": HBS Press, 1999

2. R. Ramasesham: "Investor Irrationality": NSE News, Aug. 2001.

3. Vikas Dhoot, Supriya Kurane "Emotions of Risk": Business World, 11 Mar. 2002

4. Vikas Dhoot & Navneet Gill "Investing Biases": Business World, 27 May 2002

5. Andrei Shleifer: "Inefficient Markets": Oxford University press, 2000
 


Gangineni Dhananjhay
Asst. Professor-Finance
MBA Department
Vivekananda School of P.G. Studies
Srinagar Colony, Punjagutta, Hyderabad-500 073
 

Source: E-mail June 25, 2007

       

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