Traditional financial theory assumes that investors with access to complete market information make decisions based on rational factors and accurate calculations. But for decades, psychologists and economists working in the field of behavioural finance have identified loopholes in this concept. Their findings suggest that real market scenarios leave investors vulnerable and contradict rational decision-making patterns. These deviations from logic and reason are attributed to information processing errors, subjective biases, human emotions, and even socio-cultural factors.
Investing decisions are often governed by instinctive reactions to market fluctuations instead of being informed by pre-determined fundamentals. As Financial Times reports, a study by behavioural finance software provider Oxford Risk found that investors could lose roughly 3% in returns every year due to emotionally driven investing decisions. During periods of high stress, like the pandemic, such losses can rise to 6–7%.
Investor behaviour is also one of the reasons why private investors generally have lower returns than a highly diversified index. A 2022 study by US-based independent investment research firm Dalbar found that the average equity fund investor earned over 10% less than the S&P 500 index, a benchmark for investments that is widely considered representative of the US stock market.
In response to market conditions, investors may experience fear, anxiety, pride, hope, disappointment, euphoria, avoidance, or regret. Often, these emotions are the cause for speculative, irrational and poorly timed decisions — like selling stocks too soon after earning a profit, or too late upon suffering a loss — wasting funds in the long run. This is partly due to the fact that people react differently to gains and losses: to the human mind, a loss to any degree appears larger than an equivalent gain.
These biases manifest in many ways. Investors tend to take greater risks to compensate for losses than to make prospective gains. They seek information that validates their assumptions and ignore critical perspectives. As seen with the hysteria around cryptocurrency, investors are likely to opt for options that garner the attention of their peers and the media. They are also inclined to hold on to plummeting stocks in a bid to avoid regret, or because they have an emotional connection to the stock — like in cases where the stock was inherited, or purchased with their first salary. Another common bias is choosing equities from one’s home country, simply because the investor grew up hearing the company’s name or has heard it frequently mentioned in the local media. Additionally, many investors are predisposed to overestimating their own abilities to consistently time the market, and refusing to learn from past mistakes. Such tendencies can result in overtrading and higher costs, investing more funds than is feasible, making short-sighted decisions and ending up with a concentrated portfolio with a multiplied quantum of risk.
Human beings learn by adapting — repeating what has worked for us, and trying to avoid what hasn’t. In the stock market, this approach fails. For instance, when the price of a share goes up, instead of selling it at a profit, investors typically buy more of that share. Traditional financial advisory measures the financial risk-taking ability of investors, but rarely considers their psychological risk ability, which is usually lower. Poor decisions are a result of inaccurately predicting, or entirely overlooking, the latter.
The investment process is riddled with pitfalls, and the human brain is not designed to take objective financial decisions or handle the complexities of financial markets. It is not our nature to keep emotions at bay while making decisions, and attempting this would prove futile. Instead, investing in the interest of long-term goals, sticking to robust fundamentals, monitoring knee-jerk reactions, maintaining a diversified portfolio, reviewing the status of investments regularly (but not obsessively), and working with a qualified advisor are steps that investors can take at their own pace, based on their tolerance for risk and knowledge of the market.