Behavioural Finance- Keeping Investor’s Emotion In Check

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  • 02 Feb 2023

Are you an emotional investor? Do market conditions often make your nervous and insecure? Well, emotional trading can cost you financially and affect how you will invest in the future. Also, these emotional extremes can trigger irrational investment decision making. Let’s look at behavioural finance to know more about emotional trading and how investors can avoid emotional trading or investing in the stock market.

Behavioural Finance and Investors

Behavioural finance is a new and rapidly growing field of study & research. Studies on behavioural finance try to understand human behaviour when it comes to money. These studies try to understand why rational people can often make irrational decisions when it comes to investing.

Behavioural finance includes psychological theories, particularly those related to economics and personal finance.

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Behavioural finance deals with investors and their investment decisions. According to the theory of behavioural finance,

  • Individuals who are capable of identifying the flaws in their behavior are capable of optimising their decisions. They are also wise enough to learn from their mistakes.
  • Anomalies are an important part of active management.
  • Individuals who believe in the fact that markets are rational are capable of relying on passive management.

Investors or traders are most vulnerable when the markets are volatile. Emotions such as fear, capitulation, panic, and depression start to surface. If you as an investor feel this way, you are certainly not alone.

Investors tend to make emotional decisions when things don’t go as they planned. It’s natural for investors to act on excitement or discomfort as quickly as possible.

It is no surprise that emotions start to change as the share market experiences a decline. Traders feel nervous. If prices drop, panic, desperation, and defeat arise. At this stage, emotional investors tend to sell at low.

Making decision in haste might seem like the right thing at that time, but it could go badly wrong.

Here are some of the biases that can affect investment decisions:

  • Confirmation Bias:

Investors often put more weight into the opinions of those who agree with them. Such investors ignore information that contradicts it. This is a type of bias in behavioral finance that limits investor’s ability to make objective decisions.

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  • Status-Quo Bias:

Change can be a scary thing for investors, which is perhaps why many tend to experiment and prefer staying invested the way they do. Such investors don’t prefer researching new ideas and trying new investments. Having a short list of go-to options might limit profit potential.

  • Bandwagon Effect

The world-famous investor- Warren Buffett caught the eye of the people by resisting the bandwagon effect. This effect speaks of investors who do what other investors are doing. Ideally, investors feel better when they are investing along with the crowd. But, as proven by Warren Buffett, resisting the bandwagon effect and investing after exhaustive research may prove to be more profitable.

  • Loss-Aversion Bias

Loss aversion bias is a part of emotional bias. Investors with loss aversion bias are affected more by the pain with the losses than with the pleasures of the gains. This is the main reason why these individuals tend to stay away from losses, as much as possible.

  • Overconfidence Bias

Investors with overconfidence bias believe that their skill as an investor is better than others' skills. While confidence as a trait is often considered a strength in many situations, but when it comes to trading, it may actually be the total opposite.

Here’re some of the tips that you can follow in order to keep emotions at the door when investing in the stock market-

1. Do in-depth research- As a trader, you have to be curious about something that's trending in the market. Research can bring in a great opportunity to identify good stocks or market sectors. Also, research can give you good knowledge about the investments.

2. Narrow down your options- On the basis of your research, narrow down the options that are available in front of you. Understand these options and see if they match your investment objective. Once you do this, it will be easier for you to make your final decision.

3. Understand the importance of diversification- Diversification often diminishes the emotional response and impulse to market volatility. It can bring confidence in investors. So, focus on diversifying your portfolio. Invest in different options, instead of only one. Diversification works across market cycles and protects your portfolio.

4. Evaluate and rebalance- If you are a long-term investor, you should often go back to your portfolio and see if any changes are required. There are three steps to rebalancing:

  • Review your asset allocation
  • Determine your investment portfolio’s current allocation
  • Buy & sell shares to rebalance your portfolio

5. Invest regularly through thick and thin- Volatile markets could occur any more time. A regular investment can let investors take advantage of the ups and downs, while helping them keep their emotions in check. So, even if you invest small, make sure you do it regularly to benefit the most from compounding.

6. Be mentally prepared for all types of outcomes- A good investor should prepare for the good as well as bad outcomes. An investor should be mentally and emotionally strong to face all types of market conditions.

To conclude, the key to investing in the stock market is to stay calm when markets get bumpy and avoid the mistakes others tend to make. Avoid getting distracted from the above behavioural bias and focus on your investment goals.

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