What is Behavioural Finance: Read in Detail

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. This is an example of behavioural finance, which can also be shown through a sample survey:

Q.1 – Two options – Get $10 or flip a coin, and if heads come up, get $20. If tails come up, you get nothing.

In the above question, the majority of the people would take the $10 as the amount is inevitable, and thus, they would not take a risk.

Q.2 – Two options – Give 10$ or flip a coin and if heads come up, give $20. If tails come up, you give nothing.

In the above question, the majority of the people would flip a coin and test their luck. They would hope for tails to come so that they do not have to pay anything.

Some investors have certain stocks in their portfolio whose value has dropped by more than 50%, yet they are not eager to sell them.

Herd Mentality

People tend to imitate each other in the market. If Rakesh Jhunjhunwala has invested in some company, retail investors will also start investing in it. They assume that since such a prominent investor has bought a stake, he must have done the research and diligence. The year 2021 has already seen some of the most bizarre events happening in the stock market. Many of these events have occurred due to the people’s sentiments and behaviour rather than the actual fundamentals or valuations.

For example: During the second wave of COVID-19 in April 2021, there was a shortage of oxygen in some hospitals in India. A company called Bombay Oxygen rose from ₹10,000 to ₹23,000 in a span of two weeks. The funny thing is that Bombay Oxygen is not related to producing or transporting oxygen at all. It is an investment company with nothing to do in the healthcare sector. Just because of “Oxygen” in the name, it rose more than 100% in the two weeks. This is behavioural investing, and it just shows that any stock can go up without any fundamental or technical reason.

In the United States, the same thing happened with companies such as GameStop and AMC. Hundreds of thousands of people coordinated on a WallStreetBets (a subreddit) and kept on buying GME and AMC, two of the most shorted stocks on the US exchange. In the end, it led to a short squeeze, and they both exploded. People became millionaires investing in GME and seeing the atmosphere; some people became too attached to the stock that they would never sell it. For them, it is a war against the big Wall Street corporates who occur in unfair practices such as naked short selling.

The difference between behavioural finance and other methods such as fundamental analysis is that the latter is rational and requires calculations. They are free from emotions, culture or any time of personal vendetta. The efficient market hypothesis can be followed in the fundamental and technical analysis as the prices account for everything.

The question is whether such behavioural investing can coexist with the traditional fundamental valuations or technical analysis. Nowadays, a stock could just rise up if millions of people decided to pump it up without being fundamentally strong. In the example of “Bombay Oxygen”, an investor earned over 100% in less than two weeks which cannot be achieved by the traditional methods in such a short span. On the other hand, behavioural investing is totally unpredictable as it is dependent on the people themselves. 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.