psychological factors affecting stock market investing
TRANSCRIPT
Introduction
“We are our own worst enemies, for the mindless decisions we make, as well as our frequent inability to learn from them.” Nowhere is this more evident than in the stock markets, where this enemy from within us has a way of making us too confident, too timid, too impulsive, and too staid - sometimes even all at once.
Bullish Market Investor is hopeful
Bearish Market Investor is fearful
Psychological Traps
Heuristic - Driven Biases
• Heuristic learning process is one in which people develop investment decision making rules through experiment, trial and error or personal experience.
• Rather than research investment ; individuals form investment rules and make investments using information that is most prominent in the media or otherwise most readily available
Heuristic driven Biases
Representatives
Overconfidence
Anchoring and Adjustment
Aversion to ambiguity
Heuristic - Driven Biases
Representatives• In this type of bias, investors base expectations upon past experience by
applying stereotypes
Example: • An investor might feel that all firms with management espousing
environmental awareness are good firms
Drawback• In this type of bias the investor applies" if then heuristic" that is if this
happens than the other thing will happen.
• As it is just based on thumb rule; it can give bad investment results
Heuristic - Driven Biases
Overconfidence• Overconfidence is when individuals are too confident in their ability to
predict
Drawback• Overconfidence can lead to increased trading and less portfolio
diversification
• It can also lead to surprises since the investor continuously underestimates the range of possible returns
Anchoring and Adjustment
• It refers to the inability to fully incorporate the impact of new information on projections
Example• An analyst may have already made a forecast for the performance of a
stock, when the firm releases new information that can have a material effect on the stock price
• The analyst being anchored by his prior projection will tend to not fully reflect the full value of the new information in his revised projections
Heuristic - Driven Biases
Psychological Traps
Frame dependence• Frame dependence implies that individuals make decisions and take
actions according to the framework within which information is received or the individual's circumstances at that time
Loss aversion
• It refers to the individual's reluctance to accept losses
• A stock may be down considerably from its purchase price, but investor holds on to it, hoping that it will recover
• You can relate this to a gambler who keeps throwing the dice, hoping to break even
Psychological Traps
Self control• Self control that is controlling one's emotions is related to frame
dependence
Example• Consider a stage of life and dividends
• A younger, affluent investor may totally avoid high dividend paying stock because of the related tax consequences and the effect on portfolio return thus this can create bias in the long term
Psychological Traps
Regret minimization• Regret is the feeling associated with making a bad decision. The investor
starts thinking, "if only I had.."
Example• After selling winning stock ,and then watching it soar even higher, the
investor starts thinking, "if only I had held on a little longer"
• Alternatively, the same investor after holding onto the stock and watching it fall back, might say," if only I had sold the stock last week"
Drawbacks• To avoid the possibilities of regret ;investors tend to stay in comfortable
investments like bonds and defensive stocks and hold on to looser investments for too long
Psychological Traps
Money illusion
• Money illusion refers to the way individuals react to inflation and its impact on investment returns
• People mostly think in nominal terms without any regard to inflation and its effects this can lead to a wrong mean variance analysis
Psychological Traps
• Psychological traps can lead to biases while making investment decisions
• So the investors must base their investment and trading decisions on rational mean variance analysis and risk return profile rather on rules based on experience and trial and error because it can lead to losses in the long term
Conclusion
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