The traditional finance model assumes that investors are very rational in their approach towards investing. However, what actually happened in the real world was quite different. If rationality assured better investment decisions, then all the experts in finance, those who know and understanding ‘investments’ should not have incurred losses. Hence, it became clear that there are certain psychological aspects which force people to make cognitive and emotional errors. All these factors gave rise to the development of behavioral finance.
Traditional finance emphasize that people are logical and are driven by reasons and independent judgment while making investment decisions. Behavioral finance differs. It proposes that ‘herd mentality’ and emotions guide most of the investment decisions. Traditional finance assumes that markets are always perfect and the price reflected in the market is the true value of that commodity (instrument). Behavioral finance proposes that due to several biases, there is always a discrepancy between market price and the intrinsic value of the commodity (instrument).
Following are some of the important reasons as to why even so called knowledgeable people make losses when it comes to their own personal investments.
- Illusions of Representation: Human beings, by nature, have a tendency to form their opinions based of stereotypes. If a particular actor is good at action films, we expect him to do similar roles in future too. If he adventures into romantic roles, then there is a high chance that we may write him off. We love the herd mentality. We believe in the illusion that past is the best representative of the future. Although sometimes this may be true, but this is also a major trap when it comes to investment. Many knowledgeable investors believe that good companies also mean good stocks. This may not hold true. Moreover, most of them try to derive some patterns (most of them are non-existing). Moreover, we tend to ignore companies which have not performed well in the past but the current conditions indicate a complete revival. Thus, even seasoned investors go astray when it comes to the aspect of judging investments based on past performance.
- Inflexibility and Adamancy: Knowledgeable people are so much attached to their opinions that they are not willing to change them despite the ground realities have gone a substantial change. This is most prominent when the investor holds a loss making stock and continues holding it just because of too much faith in the company’s future revival. At the root of this tendency is the emotion of fear. Inflexibly is one of the major reasons why major chunk of the investment is completely wiped off.
- Risk-Aversion: The world of investments is such that, many times, everything seems to be uncertain. Under such situations, people tend to feel that their knowledge is insufficient to judge the possible outcomes. Due to this risk aversion, people begin to stick to those things they know, even if those things are not profitable at all. They begin to get biased and obsessed with safety due to which many good opportunities are wasted.
- Arithmetical ignorance: Even well qualified people tend to make silly mistakes when it comes to business arithmetic. For example, people do not consider inflation. Due to inflation your actual dollars will have lesser purchasing power even if they are greater than in number. This type of money illusion is very common. Moreover, people are not trained to think in probabilities. They do not realize the importance of compounding. People get attracted to big number although they are useless in their decision making and they pretty often ignore the smaller ones which can have tremendous impact on their coffers.
- Overconfidence: If at all there is one unpardonable enemy of investing, it is overconfidence. At the root of overconfidence is the grand illusion of knowledge. One must remember that how so ever you are knowledgeable you are, your forecasts would always go haywire in uncertain situations. Besides knowledge, the human tendency to believe that everything is in their control contributes a lot towards failed investments in uncertain environment.
If the investor keeps his calm when it comes to above issues, he can minimize his losses from investments tremendously under uncertain circumstance.
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