Behavioural Finance: How Psychology Impacts Investing
It is not only the fundamental or technical analysis that determines the price of a stock. Sometimes, it is the psychological behaviour of the investors, particularly the retail investors, which leads to changes in the stock market. This area of studying how psychological decisions can affect the market and its outcomes is called Behavioural Finance.
A simple example of behavioural investing would be buying a stock because it is attached to a person somehow. Rather than calculating risk vs reward and being rational, people make financial decisions based on their emotions and feelings. It is now considered as a subsection of the broad field of Economics and Finance.
Loss Aversion
Sometimes, a stock goes down due to fundamental or technical reasons when you expected it to go up. During such times, many retail investors cling on to their capital as they are too invested in the company. This is an example of people listening to their emotions and intuition rather than fundamentals. In such a case, having a stop loss is always essential while making any trade. The above example is called loss aversion.
In simple words, people are sadder at losses than they are happy at gains. If someone gains ₹1000 and loses ₹1000 on consecutive days, they would be more upset about the loss than they are content with the gain, which is an example of behavioural finance.
Herd Mentality
People tend to imitate each other in the market. If some top-notch investor has invested in some company, retail investors will also start investing in it. They assume that since a prominent investor has bought a stake, he must have done the research and diligence. This is referred to as herd mentality.
Quick Learning
The difference between behavioural finance and other methods such as fundamental analysis is that the latter is rational and requires calculations and are free from emotions, culture or any type of personal affection or vendetta. The efficient market hypothesis can be followed in the fundamental and technical analysis as the prices account for everything.
On the other hand, behavioural investing is totally unpredictable as it is dependent on the people and their emotions. To be a part of the herd is an individual’s choice and one should always think practically and rationally while even investing in public-driven stocks.
Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.