Why do investors make irrational financial choices? How do emotions impact their decisions? Behavioural finance — a field of study that applies behavioural and cognitive psychological theory to conventional economics and finance — gives answers to these questions. Let’s explore some vital concepts that behavioural finance experts believe contribute to irrational financial decision-making.
The concept of anchoring
Modern behavioural economics anchors investors’ behaviour to a reference point in their past. It is only human to anchor thoughts to a reference point even though it may have no logical bearing on the investment decision at hand.
Take, for example, a young investor accumulating financial assets in an equity mutual fund that has been performing poorly after good returns in the initial years. The investor is anchoring on a recent high that the MF has achieved and, consequently, believes the current drop in price provides an opportunity to buy units at a discount or average his purchase price. He feels the performance may show a sharp drop in net asset value (NAV) and he could take advantage of the short-term volatility. However, has the investor evaluated if the fund has underperformed due to changes in the underlying fundamentals?
As an investor, you need to remain cautious towards anchoring to the past, especially when the prospects of the then invested securities looked bright. The recent decline in mutual funds’ NAV may not be temporary and, by investing more of the money in the same asset, you may fail to meet a critical future liability. Surely, you can benefit from looking into the future from the current position and not from the past anchor.
On the other hand, consider an investor who is impressed by the phenomenal returns provided by the Indian IT sector over the past few years. He wishes to join the party along with other investors. It is likely that the sector’s valuation has already peaked and may even be overvalued. The investor is probably anchoring on the past growth and is unmindful of the possibility of slower growth.
Consider another investor who has moved asset classes. A retiree who moves money from fixed deposits (FD) to equity or debt MFs would compare returns from an equity MF with those from FDs even though a direct comparison is not valid since the risk-return of these two investments is different. The retiree would benefit from overcoming his mindset from the past. The equity market in the short run tends to be volatile, but the long-term return potential remains high. Thus, the equity asset class is regarded as a feasible option for investors desiring to build a large corpus over the long term compared to FDs, which are considered for stable returns.
Also, if the elderly were to invest in a debt MF, he might be anchored to link the expected debt fund returns with FD returns. So, the investor should be aware of the risk of investing in a debt MF when interest rates are high, for this translates into returns that are lower than expected at the time of purchase. The investor should understand that the long-duration debt MF usually gives long-term stable returns.
Often, the minds of investors are clouded with emotions and past experiences. This means that while their decisions are normal and smart, sometimes they may turn out to be irrational. So, it is essential to increase their smart behaviour over irrational behaviour — acting smart when their thinking and feelings drive them to be irrational. The investor should start understanding the psychology behind investment biases and practical ways of overcoming them and then only he will have an edge to make smart financial decisions.
By Sudipto Roy
The writer is managing director, Principal Retirement Advisors