Behavioral finance explores how psychological factors, emotions, and cognitive biases influence investor decision-making, often leading to irrational choices that deviate from traditional finance's assumption of logical, data-driven behavior.
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Let's look at behavioral finance.
And this is totally different from your
traditional finance which is what you
are used to. Yeah, you've been taught
traditional finance all of your life.
Especially if you remember your
efficient market hypothesis that
that
tells you that there are different types
of market. There's a weak market,
there's semi- strong market and there is
a strong market which is about how
investors react to information available
in the stock market. Yeah. So in your
traditional finance what you expect is
that investors are logical. Yeah. And
what do we mean by they logical? You
Rational decision is what you expect.
And how do they take this rational
decision? You expect them to use
empirical data. You expect them to use
fundamentals, ratios, you know, price
earning ratios, good cash flows to
decide what stock should they invest in.
So you expect them to do a lot of work.
You expect their decision to be based on
verifiable evidence, information, data
before they take decision. That is
consistent with your efficient market
hypothesis. Information and investors response.
response.
However, this is not what behavioral
finance is all about. So, this is
traditional finance.
However, there's a school of thought
that believes that investors
most times or sometimes don't even use
any of this data.
We have seen that investors sometimes
now base their decisions on simply emotions,
Yeah. Or even other reasons but not data.
So when investors are using all of this
apart from the data that you are used to
which you expect them to use then that
is what behavioral finance is talking
about. So behavioral finance is a study
on how investors
investors
use emotions to take investment decision,
decision,
emotions, social factors. So this
part of finance is looking at why do
people make irrational decisions? We
expect them to take rational decisions.
Why do they take irrational decisions?
And they do that because of several
biases, which is what we're going to
cover now in this videos. So I'm going
to talk about all the biases. I'll tell
you their meanings and give you an
example just to help you in your studies
because this can be tested easily in
your two three marks questions.
So what are those biases that make
investors take irrational decisions?
So the first one I'm going to look at is
Remember we are looking at behaviors
that are contrary to logic that are
contrary to
rational behavior. So this is almost
saying that people are taking decision
without information that is empirical,
without fundamental details, without
ratios, without analysis. They're just
using their mind, their emotions, their
beliefs. So that's what we're looking at
and there are different types of such
beliefs. The first one is confirmation
bias. So for confirmation buyers, what
we're saying is that investor tends to
look for information that will confirm
their personal belief. So they already
have a belief. So they only looking for
information that support that belief. So
any information that doesn't support
that belief, they are quick to just push
it aside. They don't pay attention. They
won't look at it. So it's more about
their personal interest, about what they
believe. So it's a selective attention
in quotes. Put it like that. So what I'm
saying is that
in information
information
that is consistent with their
their
That's it. So they ignore contrary
information. So that's why I call it
selective attention.
So they don't pay attention to anything
that is contrary. They only pay
attention to things that are consistent
with what they initially believe. And a
typical example
will be when you have an investor that
believes that a particular stock should
be going up,
that kind of investor will only be
looking for good news because the only
good news that will make share price to
be going up. So if it sees
a bad news about that particular stock,
that investor will be quick to push it
aside and will not read it, will not
even dig deeper. Right? So an example is
a bullish remember bullish investors are
investors that believe that share price
will go up. So an example is a bullish investor
only good news about the stock
or will pay attention only to good news about
about
a stock.
Because in his mind he already has
the mindset that that particular stock
will be going up and he's bullish about it.
it.
That's one. Another one is what we call anchoring.
anchoring.
This is another bias
anchoring and from the word anchor you
know what we are saying here is an
investor that will be stuck on initial information.
information.
So even when the new information is
coming he's not paying attention to it
because he had
initial information and that initial
information is what is anchoring on. So
any decision that he wants to take is
based on that initial information, the
original information. Even if new things
have happened, new information is
available, is not looking into that. So
we're saying an investor is getting stuck
stuck on
on
On initial information.
information.
new decision,
you're about to take a decision whether
to buy a share now or not. You're not
you're not looking at the current
information. You want to sell a share.
You're not looking at current
information. You're just focused on the
original information you have. So,
another way to think about it is to say
this is a starting point hook. So,
you're only focusing on your starting
Yeah. And a typical example is when you
buy a share, say you buy a share for $10,
$10,
then while you are holding that
the share price starts to go down.
Probably a bad news comes out about this
company. So a share that you bought for
$10 all of a sudden starts to go down to
even $5, $7,
then you say no, you are not going to sell
sell
because you believe that the share price
will come back and will still rise
beyond the $10 entry point, your cost
price. So you are anchoring on that
original point of entry, which is your
$10. Yeah. And that is anchoring. Yeah.
I think at this point I also mentioned
to you that some of these behaviors can
be linked to other behaviors. Yeah.
Because what I just described to you
also can be similar to I mean loss of
action. So it's possible to have a
scenario that you can actually describe
as exhibiting two different types of
behavior. Right? So
to put it down an example. So let's say
the initial information is the cost
price of this shares. Yeah.
So initial info
of stock. Yeah.
Standards.
to sell
go below beyond $10. So, he's waiting
for it to rise above the initial price
of $10 before he can sell. So it's
anchoring on that original information.
The investor is anchoring on the
original price, the initial price and
that is anchoring.
Talking another one about conservativism.
conservativism. Conservatism.
Conservatism. Very simple. So this one
is just when an investor is very reluctant
reluctant to change even when there is
no information available. So despite
to reluctant to change your belief let
me put it in detail so I can get it
Yeah. So
So
you have a portfolio of different stocks
and companies and you're getting
information that a particular company is
not doing well. The normal thing you
should do is to sell that particular
stock out of your portfolio because you
don't want it to get even worse.
However, if you're a conservatism biased
person, you will not want to change your
portfolio structure. So, you want to
stick to it. In that case, you are
holding on to what you should not be
holding on just because you're being
conservative. Yeah. So, like I said, an
example is not changing your asset allocation.
allocation. Yeah.
an asset allocation. Asset allocation is
about the component of your asset in
bad information.
about info about
about some
some stocks
stocks
Yeah. So that is conservatism.
You don't want to change your belief.
You're very conservative.
Yeah. Conservatism. That's it. Very
straightforward and direct. Moving to
Mental accounting.
This one is funny because we all exhibit
this. And this is when you treat money
based on the source. So this is about
based on it source.
You know
there are different ways of getting
money. Might be a gift, might be your
salary, it might be your bonus.
So sometimes we believe that when we
work hard for money, we spend a lot of
time thinking and planning how to spend
that money judiciously. You're very
careful. Whereas if it is a gift or a bonus,
bonus,
some people or some of us, we care less
about how we want to spend it. You see,
when you just carelessly spend the
money, you don't care. You can buy
whatever you want to buy. You're not
thinking about the return. You just want
to spend the way you like because it's
almost like a free money. Money is money
and you should not do mental accounting.
You should have a one principle of
spending your money. So it's funny but
it's actually the reality. So this is
about careless
example is when you do a careless spending
you're not doing so much research on
where you want to put the money and what
you want to do with the money because
you believe it's a bonus. So careless
spending of gift
cash or bonus.
Yeah. Whereas
you're very careful
when you're spending your salary because
how to spend salary
because you work so hard for that one.
So you believe that's the only part of
money you should be careful. No, you
should be careful with everything. odd
money. That's mental accounting.
Another one is loss aversion. I touched
on this one briefly earlier on. Yeah. So
this is when someone feels so much pain
with 10% of loss than 10% of gain. So
normally you expect that if you make 10%
of gain the same way you are happy
should be the same way you will be
unhappy when you make 10% of loss.
That is what you expect. However, if
someone is expecting this loss aversion,
they feel so sad, so horrible when they
are making loss, but the same amount of
gain, they are just okay. They're not
super excited as you will see, you
expect, right? And that is why you see
someone that will be selling gain too
early. Yeah. Because they made profit
and they just feel like it's okay, we'll
move on. But when it is a loss, they
feel so sad that they are holding on to
it. They can't bear it. They just don't
want it to crystallize. So they will
hold on to that shares until they
believe that it will come up. It might
come up, it might not come up or it
might take forever to come up, which if
you have sold it, minimize your loss.
You could have invested in something
else and even probably you would have
made so much profit times four times 5
of what you have been holding on. Right?
So this is when investor
does not want to accept a loss. They
don't want loss to crystallize. Right?
So you feel more pain loss
loss
joy. Let me put like that
on same amount
amount
of gain.
Yeah, that's to put in a simple way.
Yeah. And what do you see?
Investor is selling
because they don't even want it to go
into a loss position at all. So they
quickly realize again so that they will
know that oh this is a gain. So you sell
again too early
but once it drops into a loss position
you cannot sell because it doesn't want
to realize the loss because you know if
you sell a share that is a loss position
you have realized the loss and that loss
has crystallized but when you are
hold loss
position for too long it might even get
So all these
are indications of loss aversion.
Another way to see it is what we call
Selling gains too early holding loss for
too long. You shouldn't do that. That's
a disposition effect and no investor
should be exhibiting that. However is
the reality will do it. So an example is
when it
it increases
So even if bad news keep coming in about
the company, you've seen that this
company is almost going into bankruptcy
which means you might lose everything.
This investor will still not sell. He
will still be believing that it will rise.
rise. But
But
that's emotion. That is not logic. That
is not data. And you can see everything
we've been dealing with no data. They
are all just random behaviors, right?
Another one which is very popular is overconfidence.
That's another bias.
Overconfidence bias here.
That's when people think they are better
that you are better than other investors,
investors,
so you're saying that you can pick a
better stock than others. You know when
to sell, you know when to buy better
than others. So you think you're better
than others
or you even overestimate your capacity.
So what we are saying is not that we're
saying that you are poor or you are bad.
You are good. However, what we're saying
is that you think you are better than
you actually are. And if that is the
situation, you will be underestimating risk.
risk.
That's what we're saying. So you
underestimate risk. You're not able to
dig deep. I should actually dig deep
into once you see a little information
you can just think you're smart and that
information is enough then you take your
decision. No, if you do that that will
and which means you are doing more than
you should. Yeah. You're using limited
information to decide. You're not
spending time to do a thorough research.
Yeah. And an example is when an investor
believes that
Yeah. So you are looking at a stock and
you think oh you know what to do. We can
always make profit from this stock.
Whether you are short selling or you are
going long on the stock or whatever, you
know what to do. You're not you're not
paying attention to the information
available. You're not doing analysis.
You're not checking fundamentals. You're
not doing technical analysis. You're not
doing anything. You just believe you
know it all. That is overconfidence.
Another behavior is hiding. Heading
Heading
is another one which is just people
copying the crowd. So when you go with
you're not doing your own assessment.
Yes, you're going with the crowd without
individual analysis.
You're not doing any analysis. You just
discover that everybody's buying the
stock and you two you decide to go and
buy the stock. Yeah. So when you buy a stock
buying a stock because
If you're buying just because of that,
you're exhibiting
heading behavior and that is not the
best. You're creating a problem for yourself.
yourself.
Still more to cover. I want to cover as
many as possible so that you will not
see anyone that you think you have not
heard of before. And that is gamblers
fallacy. That's the next one I'm talking
about. Yeah. Gamblers's fallacy is when
an investor expects
a future event because of another random
past event. No analysis, no data. You
just expect that a future event will happen
because
of a random
past event. It's random because it's not
data. It's just you're just using any
information in the past to hook your
decision on to say yeah take for
instance the share price has been going
down the whole of last week. So share
price going down for past week and you
say oh because of that in your mind you
you expect the price to go up.
Now you can see that there is no logic
there. There is no analysis. There is no
nothing technical, no fundamentals. You
have just based your decision on random
event. You don't even know why the share
price was going down last week. Maybe
the company is collapsing and everybody
is selling
which means it will keep going down. But
instead of you to act based on that, you
decided to act contrary thinking yeah
things will turn around without any
data. So you're not using fundamental.
Next is Einsteid bias.
bias.
Einide and you see from the word itself
inside about the past. Yeah. So this is
a behavior when an investor believes that
that
event could have been predicted. Simple.
So when something has happened and
because of the benefit of hindsight you
just believe that oh I could have
predicted this one. We knew this will
happen but before it happened you did
not predict it. But it's very easy for
you to say ah no no no I could imagine
yeah we were expecting this to happen
actually I think I just kept quiet no
and that's why sometime the side bas
leads to over confidence because the
next thing you now start thinking you
can predict the next thing that will happen
happen
so it's very interesting topic so this
is a belief that event could have been predicted
when we know definitely that stock
market is highly unpredictable. Yeah,
like I said this can actually lead to
have over confidence. Yeah. So an
example is when
an investor say I knew this will happen.
Yeah. When you hear an investor saying
that is exhibiting hindsight bias. So
when when an investor says I knew
or the share price of a company.
Yeah. or maybe a price of a share would crash
after
it has actually crashed
that is a bias.
It is not based on fundamentals because
why didn't you tell us before it happened?
happened?
Next I'm going to be touching on is
availability bias.
A lot of interesting biases.
Yeah. And here you see an investor
attaching so much value to information
just because they are readily available.
Simple. So when an investor attaches
so much
when you attach so much value.
value.
Yeah. Which means you believe it so much
and you're acting based on that value to information
information
readily available
and you can reckon with this the most
readily available information is news.
Wherever you are sitting news will just
come to you. You don't even need to
search for them. Yeah, there are news
that you have to search for but there
are news that will just come to you
naturally. So if you are acting based on
those those news that just naturally
comes to you, you're exhibiting
availability by us.
only news
news without
effort
to to dig
deeper or do analysis.
Cuz even when you get some news, you
probably still need to do some analysis,
calculate some ratios, you know, look
for more information before you take
decision. That is rational behavior. But
when you don't do that and you're just
focusing on available information
without asking whether they even true or
not, whether they even even more
contrary information you can find.
You're not searching. You just focus on
what is readily available to you. Then
that is available. availability bias.
The last one I'm going to be touching on
very funny one again is the recency bias.
Recency bias is when you take decision
based on the recent experience based on
the recent
happenings around you. In fact, typical
example is think about this look at the
aviation industry. You know that
I mean transport by here flights is
still the safest very safe
compared with the number of flights that
travels in a day and the number of
accidents you will see you realize that
it's quite very safe. But if you
probably hear news recently about plane crash
crash
or maybe it even happens close to you
that you even saw it around you.
You will discover that there are people
that will probably have a flight the
next week or or few days after but they
will cancel their flight. They afraid or
even when they fly and they in that
plane just a little turbulence they are
shaking and they are praying and they
are you know almost thinking their plane
will crash of which if they did not know
about any news about plane crash they
will not even feel any different. So all
of a sudden the recent event the crash
event has changed your mind and you are
thinking like aviation flight has now
become very unsafe. So that is not
logic. Logic is that it remains the
safest way of flying. It's very safe but
the recent event has be clouded your
mind and you are thinking you are not
safe. So that is recency by ask. So this
is when an investor expect recent event
to reoccur.
Yeah. when you expect
a recent event
Yeah. And therefore that will affect
your decision because you want to avoid
or do it depend on the recent the nature
of the recent event. Yeah. It will
affect your decision. If it's a good
recent event, you want to do it again
because you think it will happen. That's
when you see someone buying a stock. He
buys the stock. The stock has gone up,
he sells it, makes money, he's happy,
then the next thing you see him buying
that stock again, thinking it's still
going to go up. Then guess what? The
stock starts to come down. Then you lose
money because you've not traded based on
logic. You've not traded based on
fundamentals. You have only been trading
on bias. And that's why a lot of people
actually lose money in stock market.
Yeah. So here you can also an example is
also maybe you are not investing in
stock because the price has been going
down or because of recent market crash.
You believe that no I'm not buying stock
again because of market crash. It's
always a cycle that is up and down but
you don't want to believe that. You're
just anchoring on your recent
information the recent experience. So
this is not investing
in a company chair
You're not checking why it's been going down.
down.
Yeah. You just feel like because it's
going down, I'm not buying it.
So those are behaviors that necessary to
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