7 Common Traits that can Affect Investor Behaviour

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  • Jun 23, 2022 - 7 Common Traits that can Affect Investor Behaviour

7 Common Traits that can Affect Investor Behaviour

Jun 23, 2022

Have you read the book - 'The Psychology of Human Misjudgement' by Charlie Munger?

When it comes to understanding why we behave the way we do - this piece of literature is a magnum opus.

In this book, Munger describes the various patterns of irrational behaviour that lead us to commit repeated mistakes. All of these are human misjudgements that impact decision-making across life stages.

Investors fall prey to these same human misjudgements that can influence their investment decisions.

In most cases, this irrationality can lead to hefty financial losses.

The Relationship Between Human Misjudgements and Investor Behaviour.

There is a high risk of making mistakes for anyone who trades in the stock market on a regular basis.

Perhaps you sold a winning stock too soon or held on to a losing stock longer than necessary.

Conventional economic theory states that all individuals are rational. The same logic applies to investors.

But that's far from the truth. Some would even call it an oversimplification of reality.

A financial services firm, Dalbar, released a research study called the 'Quantitative Analysis of Investor Behaviour' in 2001.

The findings of the study showed that investors are repeatedly unsuccessful at achieving the profits that beat or are at par with the broader market indices. What this means is that the investing is rampant with psychological pitfalls.

You can attribute this directly to investor behaviour.

This is studied in the field of behavioural finance.

Kaplan Financial Education defines behavioural finance as 'The study of psychological influences on investors and financial markets.

So, what's the interrelation between investor behaviour and human misjudgements?

The goal here is avoid making these common investment mistakes driven by our behavioural traits. To achieve this, investors must become fully aware of their biases. Only then can they make impartial investment decisions.

The 7 Behavioural Traits that Affect Investing

Benjamin Graham rightly said, "The investor's chief problem - and even his worst enemy - is likely to be himself."

Often, investors experience a roller coaster of emotions during their investment journey. This results in decisions taken by investors that are flawed as a result of emotions nearly always overriding reasoning.

So, what are these common behavioural traits that can influence investment decisions? Let's find out.

These behavioural traits are even more important in the current market where investors are largely sceptical, and many are making rash decisions.

#1 Fear of Regrets

The theory of regret aversion defines a bias in investors when he or she is unable to decide due to fear that the decision will turn out to be wrong. Later on, it may have feelings of regret.

A classic example of the regret theory is when investors realise, they have made an error in judgement.

This is likely to occur when investors are faced with the prospect of selling or buying a stock at a price that emotionally affects them.

Perhaps they had to sell the stock at a loss.

Or the stock went up in price and they missed the chance to buy it at a lower level.

Many investors may choose to avoid the sale completely. The reason could be to avoid the regret of holding on to it for longer than necessary. Or perhaps they simply do not want to be embarrassed to book a loss.

The objective here is to avoid emotional pain which is a by-product of regret.

#2 Mental Accounting

The mental accounting behavioural trait often leads investors to make irrational investment decisions. They can behave in financially detrimental ways.

For example, an investor may own two stocks - one that is rallying and the other that is constantly falling.

Mental accounting will drive the investor to sell the stock that is on a positive run. Here selling the loss-making share is perhaps the more logical decision.

This is because most people tend to compartmentalise events in their minds.

In this case, the investor made huge gains in a bullish market. But eventually, the market corrected and that deflated the investor's net worth.

The hesitancy stems from having to sell at a small profit. In their mind, they want to wait for profits to return to what they were during the bull market.

#3 Prospect and Loss Aversion Theory

It is human nature to treat gains and losses differently.

Prospect theory suggests how investors will choose between probabilistic options, where risk is involved, and the possibility of diverse outcomes is not known.

In simple words, when it comes to investment decision making, the calculation is done on perceived gains and not on perceived losses.

This is because investors are more stressed by the prospective losses compared to the happiness of equal gains. To them, the prospective loss appears to be larger than a gain of equal proportions.

This is related with loss aversion theory which points out why investors may want to curtail losses. This is because losses appear greater than gains, even if the likelihood of those losses is insignificant.

For example, an investor may continue to hold onto stocks that are incurring losses and sell off the winners. The reasoning is perhaps the hope that the losing streak will end, and the stocks will bounce back.

#4 Anchoring

It is a common trait among investors to assume that the market price of a stock is the correct price in the absence of better or new information.

The trust and faith in recent market trends, views, opinions, and events are significantly high.

But the reality may be completely different. This can only come to light if the investor looks at historical, long-term averages and probabilities instead of basing decisions on current trends only.

Anchoring is a trait in behavioural finance that focuses too much on current details, which leads to errors in decision making.

For instance, investors often look at the figure of a 52 week high or low price of a particular stock at the point of purchase. This initial information is the 'anchor'.

The investor may decide to purchase the stock because the current price looks cheap even if the stock is overvalued.

#5 Over and Under-Reacting

Simply put, an over or under reaction is an extreme emotional response.

It's an emotional response that is guided by fear or greed.

For example, optimism among investors overflows when the markets rise. They assume confidently that the boom will continue for some time. On the other hand, the same investors turn pessimistic when the market falls.

This is the result of placing too much importance on recent market trends and disregarding historical data.

This is basically an over or under-reaction to market events. It typically happens when there is a meteoric rise or fall in stock prices depending on news.

When the investor is optimistic the behaviour is to buy stocks beyond their intrinsic values. Severe instances of over or under-reaction to market events may lead to market panics and crashes.

#6 Overconfidence

Every investor thinks that he or she knows best.

This behavioural trait drives them to rate their abilities as being above average. This can be defined as overconfidence when people, in general, tend to overestimate their skills.

This assumption of superior knowledge can lead to overestimating their knowledge in relation to other investors. This can lead them to disregard data and expert advice. This can interfere with their ability to practice good risk management.

The investor is under the impression that he or she can consistently beat the market by making risky bets without possessing the right analytical skills.

Overconfidence in timing the market can result in excess trades, with trading costs denting profits.

#7 Herd Mentality

Human beings, since the beginning of time, have preferred to live and operate in groups. The herd mentality is ingrained in us.

This is mostly because humans are social animals and being part of a group assures them of social acceptance.

Investors are no different. This is also called the bandwagon effect.

They are prone to mirroring what other investors are doing or following recommendations without thinking it through.

For example, when a group of investors buy a stock, the price may start to go up.

An investor may choose to become a part of this group. The rationale behind this behaviour is that the group has access to information the single investor does not.

But going with the herd is a result of emotion rather than independent analysis.

Social factors like peer pressure can lead to this self-deception where you limit your knowledge and depend on others to fill the gap.

There is also the fear of doing things differently that drives investors to follow prevalent patterns instead of going against the crowd.

Can Investors Overcome their Behavioural Traits?

There isn't a magic cure for behavioural traits or biases with which one is born. The way forward is to mitigate the effects.

A great place to start is to identify your behavioural traits early on in your investment journey. It is also important to understand how these biases influence your investment decision making. That will help investors avoid mistakes.

Focus on being objective. Adopt a practical approach to investing supported by facts, both recent and historic.

Build a framework that works with your financial goals. Support that by following a rule-based analysis of the numbers. Also develop an understanding of market dynamics.

All this can strengthen your investment decision-making ability and help you in your wealth creation journey.

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...

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