Suleman Ayub

Behavioural Biases that Work Against Rational Decision-Making by Investors 1 Financial decision-making is closely knitted with behavioural aspects of people. Everyone tries to act rational while making decisions, though not all really acting rationally. Efficient markets or not, still many people make decisions based on wrong information, or the limited one that is most readily available to them, resulting in alteration of market prices and sometimes forming temporary trends. Making a hasty or improperly informed decision about stocks can prove to be very costly. It is difficult to find a trend in which the stocks perform; one cannot be certain that after going down, a stock shall rise back again anytime soon or shall see a big raise in its price. Although theoretically, stocks should outperform bonds in their yields, considering that they are riskier and hence contain a risk premium; however, nothing can be said with surety that they must outperform a similar bond in real world. Similarly, assigning investment decisions to a broker or simply buying a mutual fund might or might not be much helpful. Indeed, the stock prices follow a “random walk” and are difficult to predict. Hence, there remains a state of confusion and uncertainty when it comes to decision-making, but luckily, great amount of it can be removed if the investor is more active and makes more informed decisions rather than taking a wild guess at it based on the market word about a stock. A rational and active investor takes extraordinary steps and tries his best to obtain all information and uses it in the best possible way that shall help him/her decide about the stocks. Selected or incomplete information joined and presented in a way that makes good sense is not going to help; one can just not take a good decision based on limited information. Research is the right tool in this regard, a successful and active investor should have a keen eye on all the detail of matters related to the company he or she is investing in. It is not just about using the current information, one has to look at things in the right perspective/context. Digging about past history and projects of a company is also worth knowing. Fisher (1996) has raised an important question while deciding on what stock to buy “Does the company have a short-range or long-range outlook in regard to profits”. Even when one made the most informed of the decisions and is very optimistic about going to have a good gain over his/her investment, it is never wise to invest the complete capital in a single stock and hence here comes the concept of having a diversified portfolio that removes specific risk of risky stocks. Placing all the bets in a single stock is not wise. A diversified portfolio is much better to eliminate any specific risk and reducing overall risk of one’s portfolio. So, even if one company defaults, the earnings from the rest of the stock can keep one afloat. Still, 2 choosing the right stock is a tricky business as people tend to show biased behaviours while making investments. It can be a case of simple ‘overconfidence’, where people miss calibrate risk to be too narrow; ‘representativeness’, where people start comparing situations with similar ones; ‘anchoring’, where people just pick the wrong benchmark to compare things against and hence all the processing is useless; and the ‘availability bias’, where people use information that is most easily available to evaluate a stock. However, these behavioural biases shape their preferences and result in a ‘bounded rationality’ which is described as the limit of a human mind and its cognitive ability and the limited time in which they have to process this information. Figure1 Combining three shares in a portfolio (Mazzucato, 2010) Though the mental ability is pretty limited and prone to errors, but still, diversification is helpful. Depending on the investor’s personal preference, he/she might chose risky stocks over non-risky ones; it is obvious that the riskier the stock, the more risk premium it offers. Risk-averse people will focus on stability of a stock more than its yield, however, many would simply want to have the maximum yield. This brings us to the concept of a ‘welldiversified portfolio’ (Mazzucato, 2010). In the stock market, some companies or some industries are considered a stable investment according to “their” experience, but again, market words are not always true and should never be relied on. Take the example of the- financial crisis which was initiated by housing bubble. Investments on residential projects were considered to be very stable and it surely was apparently in the beginning; however too much trust in the housing industry initiated the crisis. Banks started to offer more expensive homes to people who originally could not afford them due to easy credit 3 policies. When too many people purchased extremely overpriced property on lease, the result was that a large number of people were not able to pay the lease instalments. The banks then confiscated the lease-defaulted properties and tried selling them on cash but there were just not many cash customers, resulting in a mass sell-out of these properties which again dropped the prices to very low because of simple demand and supply dynamics. This crisis hit the world pretty hard, affecting several countries throughout the world and initiated by simple miss evaluation of housing projects and their ‘real value’. Many banks and insurance companies that insured these projects went bankrupt as a result. Profits are very attractive for most people and a higher profiting stock can be irresistible on the outlook but can be extremely risky in real. However, when people continue to follow market trends, they make a mistake of not evaluating properly and making a miss-informed guess. For most people, they just cannot resist the stock giving good returns over the stability of the other. However, when it comes to managing investments and portfolios over a long period of time, stability is a much sought after thing. Hence, an informed investor should understand laws of probability to forecast price and yields of their stocks. If the investor does not possess required skills and knowledge to evaluate, then he/she is indeed better off buying a bond or a debenture with a fixed rate of return. Stocks are similar to betting and just as people tend to have emotional value associated with a particular horse in the betting, similarly people sometimes create too much expectations of an investment that used to give good returns in the past. Thus, it is indeed pretty difficult to evaluate an investment properly and keeping in view the limited ability of human mind, it is much more difficult, but knowing what can go wrong puts one in a better position to avoid it. I would agree that people should unlearn what they have learned about stocks and start with a more self-reliant approach towards it and that the evidence clearly suggests biased behaviours practised by people. Knowing these biases and knowing the mistakes that they can make, can help them avoid it. One should try to fetch all possible information related to an investment and apply the laws of probability in the best possible way to ensure a correct estimate. 4 References Edwards, R. and Magee, J. 1997. Technical analysis of stock trends. Chicago: J. Magee. Fisher, P. 1996. Common stocks and uncommon profits and other writings by Philip A. Fisher. New York: Wiley. Hafer, R. and Hein, S. 2007. The stock market. Westport, Conn.: Greenwood Press. Jorgenson, D. and Yun, K. 1996. Investment. Cambridge, Mass.: MIT Press. Mazzucato, M. 2010. Personal investment. Basingstoke: Palgrave MacMillan, in association with The Open University. Open.ac.uk. 2013. Online Unit 6 Exploring investment behaviour. [online] Available at: http://www.open.ac.uk/ [Accessed: 7 Sep 2013]. 5