Behavioural Finance: The Psychology of Investing

What compels people to invest has been an intriguing topic among finance enthusiasts. Is it the big numbers? Is it curiosity? Is it the adrenaline rush? Or is it the theoretical aspects of investing, such as efficient management of money, risk aversion and so on? Traditionally, the perception has been that all investors are rational and their investment decisions are driven by a sound understanding of the market and its complexities and an accurate forecast of the risk factor. However, the psychology behind investing is a complex subject. Investors are driven by factors other than just rationality or an in-depth knowledge of market movements. Moreover, there is always the factor of uncertainty that dictates the way investors invest their money in the market.

Oftentimes, this factor of uncertainty is more psychological than practical. If it is the notion that all investment decisions are arrived at without any emotional considerations, then what explains the sudden upward or downward trends in the market? Unlike popular belief, most investments in the market are rather instinctive than well-planned and thought-out. The term ‘Behavioural Finance’ represents the phenomenon of investors’ psychology influencing investment decisions and its effects on the market.

One of the known instances of emotional decision-making is when there is a sudden change in weather and the subsequent market movements are influenced by it, or natural disasters like earthquakes or storms in a particular geographic location define investment decisions. Another example could be when people invest based on their ‘gut feeling’ or their belief that an investment will perform better than any other investment. There is no logical explanation for such decisions, they are driven purely by the investors’ emotions coupled with their over-optimism and self-confidence.

When it comes to the stock market, it has been observed that investors prefer to lean towards legacy stocks over others as it is popularly believed that legacy stocks are low risk and high performance. Again, there may be historical evidence or a future projection of poor performance for a particular stock. Still, if it is a legacy stock, investors will be compelled to invest in it. History is also one psychological factor that influences many investment decisions. If a stock or an investment has a history of good performance and positive returns, investors may hold on to it for the long term or pay a premium price to acquire such investments.

Chain reactions or hoard behaviour is another common investment phenomenon guided by psychology. In this case, one or more investors react or make investment decisions based on a common belief. Such reactions are often based on rumours or misinformation circulating about the performance of that investment. Hoard behaviour is also observed when a significant amount of investors act upon or follow tips or investment advice from an ‘Investment Guru’. Such advice may or may not be solicited and it may turn out to be a huge loss for the investors.

Understanding these psychological biases can help investors and financial professionals make more rational decisions by being aware of the potential pitfalls and implementing strategies to mitigate the impact of these biases. Techniques such as setting clear investment goals, diversifying portfolios, and adopting a disciplined, long-term approach can be effective in countering the irrational behaviours associated with behavioural finance. Smart investment demands the investor and financial professional to be emotionally intelligent and understand the traditional finance models within the shadows of behavioural finance.

The author is Assistant Professor-Finance​, SBM, NMIMS Hyderabad. Views are personal.