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Tuesday, May 7, 2019

Mastering the Nuances of Individual Investor Behaviour

The study of behavioural finance has brought a new wave of transformation in the finance industry.

Investors usually are hasty when it comes to investing their funds. They tend to react per the information shared with them and the amount they have to invest. A lot of factors should be considered before investing anywhere. This blog helps to understand the behaviour of investors and what leads them to lock an investment.

Many economic theories are based on the notion that individuals behave rationally and every existing information is set in the investment process. An efficient market hypothesis is the crux of this assumption theory.

However, several researchers have nullified this assumption of rational behaviour.
Behavioural finance aims to study the way human emotions affect investors in their decision-making process.

Behavioural Science

Many investors believe that traditional or behavioural theories of finance affect investment decisions. Those who apply the traditional finance school of thought while investing should determine the basic value and the securities they want to invest in.  In case the securities of interest are overvalued or undervalued, the determination of the fundamental value is geared towards establishing investments.

To follow this process, it requires valuation techniques and formulas. Whereas it is also suggested by behavioural finance that investors use their psychological knowledge in making investment decisions. It requires the application of various rules of thumbs while making any kind of investment decision.

According to the theory of risk and return on investment decisions, the more the risk of investment, the more are the returns, considering the level of accepted risk. Some strategies that an investor can adapt to stay ahead in the game are applying industry best practices, rational risk management, and proper portfolio construction and management.

The experts of behavioural finance ideology state that the decisions on investments are based on factors such as endowment, regret aversion, loss aversion, mental accounting, herding behaviour and cognitive factors including overconfidence, gambler's fallacy, and hindsight biases.

Investment Decisions

Individual investors are different from institutional investors in terms of their investment horizons, investment profiles, and the amount of money disbursed on an investment venture. An individual investor acts on his own will, as a private entity, while institutional investors are usually companies. They include entities such as hedge funds, insurance companies, commercial banks, mutual funds, and endowment funds.

Investment choices involve the resolution of which security or asset to invest in, how much to invest, when to invest, and the investment period. Different investment alternatives differ in their risk and return profiles—the risk appetite of an investor determines different alternative investment and whether to invest their money in either shares, bonds, marketplaces, securities, or other securities traded at NSE.

Dalbar, a financial-services research firm in 2001 released their study titled "Quantitative Analysis of Investor Behaviour," which concluded that most investors fail to achieve market-index returns. Let us tap into the reasons why this is happening and how behaviour affects the investment.

Regret Theory

When a person realises they have made a mistake in judgement, he/she deals with the emotional reaction of experiencing a fear of regret. This emotional reaction is called Regret theory. Investors become emotionally affected by the price at which they purchase the stock and have to overcome the idea of selling a stock.

Regret theory is applied in the case when an investor discovers that a stock which was considered by them to purchase has increased in value. Some investors go with the public and purchase the stocks which are being bought by everyone else justifying their decision with "everyone else is doing it."

What is peculiar is that most of the investors feel less embarrassed about losing their money to a popular stock that half the world holds than about losing their money on an unknown or unpopular stock.

Mental Accounting

Humans have an inclination to place certain events into mental compartments because human behaviour is impacted by more than just the events.

Assume an instance where one aims to catch a show at the local cinemas and tickets are Rs 500 each. When you get there, you realise you've lost a Rs 500 bill. But you still buy a Rs 500 ticket for the show anyway? As per behavioural science, it is found out that nearly 80% of people who go through this situation would buy another ticket.

Let us assume that someone has paid Rs 500 for a ticket in advance. On arriving home, the person finds out that the ticket is at home. Now, will the person pay Rs 500 to purchase another ticket? As per behavioural science, only 40 % of the investors would purchase another ticket.

It is intriguing to observe that the same amount of money is lost in both situations but different mental compartments are shared.  

The best explanation of mental accounting is the delay in selling an investment that once observed huge gains and now is experiencing average gains. When the market is experiencing a bullish trend, the economy is booming, hence investors get accustomed to healthy returns. While deflation, the net worth of investors reduces making them more hesitant to sell at a smaller profit margin. These investors cause mental accounting to create mental compartments for the gains they once had.

Prospect/Loss-Aversion Theory

It is evident that people prefer investment returns to uncertain ones where people want to get paid for taking extra risk. Prospect theory is when people show a different angle of their emotions towards gains than towards losses. People fail to enjoy gains and instead are more stressed by proposed losses.

When a client's portfolio experiences a gain of Rs 5,00,000, no investor advisor will get swamped with calls. However, if a client incurs a loss of Rs 5,00,000, the phone won't stop ringing for the advisor, hence concluding that a loss will always be given more importance than a gain of the same amount.

Another reason is put forward by the loss-aversion theory for investors to choose to hold their losses and sell what they have won. Investors believe that those who have lost today can turn out to be potential investors tomorrow. Most investors make the mistake of following the herd and invest in stocks or funds which are popular amongst other investors. Various researches point out that money flows into high-performance mutual funds or alternative investments like invoice discounting faster than money flowing out from underperforming funds.


It has happened that the absence of substantial information has led investors to believe that the market price is the correct price. Due to this a lot of faith is put by the investors in the recent market views, opinions and events, and mistakenly extrapolate current trends which are different from historical, long-term averages and expectations.

During the bullish trend of the market, the decisions of investments are usually determined by price anchors, which are the prices considered essential because of their closeness to recent prices. This makes the returns of the past trivial in investors' decisions.


When the market experiences a boom, investors experience optimism assuming an upward trend in the market to follow. However, investors become very negative during downturns. Over or under reaction to market events is when an investor anchors, or places too much emphasis on recent events while sidelining historical data leading to prices falling too much on bad news and rising too much on good news.


The general trend is for people to rank themselves higher than their average abilities. Furthermore, they also exceed the accuracy of their knowledge and their knowledge relative to others.

Although many investors share the belief that can consistently time the market, there is a vast amount of evidence that proves otherwise — overconfidence results in excess businesses, where trading costs can sink profits.


Behavioural finance inevitably reveals some of the characteristics rooted in the investment system. Behaviourists will dispute that investors frequently behave irrationally, producing mispriced securities and inefficient markets not forgetting the opportunities to make money.

It can be true for some instances but continuously tapping these inabilities is a challenge. The question remains whether these behavioural finance theories can be used to handle money economically and effectively.

That said, at times investors can turn out to be their own enemies. Investors are always trying to figure out whether the market will pay over the long term which often results in unusual, unreasonable behaviour, not to mention a dent in your wealth.

Implementing and following a strategy which is well thought out can help investors avoid many of these common investing mistakes.

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