DO YOU KNOW YOURSELF WELL ENOUGH?

The stock market is full of uncertainty. No one really knows what lies ahead. Still, the so-called market experts keep on predicting stock prices every minute. However, for financial economists, the market provides an interesting avenue for research. The academic researchers are mainly divided into two major groups. One is the proponent of Efficient Market Hypothesis (EMH) and the others are the believers of inefficient markets.

The formal definition of EMH was provided by Eugine Fama in 1965. EMH states that all available information is already reflected in the stock price. Hence the present price of any security is the correct price and it is not feasible to predict the future price. EMH believes that the markets are efficient and the investors are rational in their decision- making. Since then for more than two decades EMH was the widely accepted theory. However, the critics of EMH started challenging the basic hypothesis as it failed to explain the sudden volatility and the burst and bubbles of the stock market.

In 1990s, the economists had started analysing the irrational behaviour of the market. This has resulted into a new research field by the name of “Behavioural Finance”. Behavioural finance is a sub branch of behavioural economics which studies the impact of investor psychology on the stock market and try to explain the anomalies. It tries to analyse and explain how investor behaviour impacts his decision in investing.

It is very surprising to see that human behaviour has not changed over centuries. We keep repeating the same mistakes over and over again. Charles MacKay’s book “Extraordinary Popular Delusions and the Madness of Crowds” published in 1841 explains how crowd psychology affects decision-making related to various financial schemes. A similar behaviour was observed since March 2020 in Indian stock market.

Behavioural finance believes that retail investors are mostly irrational and hence they tend to make investment decisions based on their sentiments, emotions, and psychological biases. The rationale behind this is that the retail investors do not have sufficient time, money, and knowledge as compared to large institutions to analyse the available information and make informed decisions. This inability to process information is called bounded rationality. This bounded rationality compels the retail investor to adopt shortcuts and rules of thumb while making investing decisions.

The prominent psychological biases displayed by investors are overconfidence, herd mentality, over optimism, social bias, loss aversion, etc. These biases impact decision-making and intern affect your finances and wealth creation. Hence, it is of utmost essential that the retail investor must understand these biases well so that he does not make irrational decisions while investing. Understanding these biases will stop him from making silly mistakes and avoid financial losses.

The recent example is the herding bias displayed by retail investors during the Covid pandemic. Despite the overvaluation of the market, the number of new investors has increased to record levels. These investors are driven by overconfidence, over optimism, and irrational exuberance. There is a need to guard oneself against such behaviour.

Investing in the stock market through equities is a serious business. It needs a lot of knowledge, study, analysis, business acumen, and time. Not everyone can have all these. This is not a cakewalk. It is not everyone’s cup of tea. So, the simplest and the safest approach for a retail investor is through mutual fund investments. However, even with this approach, one needs to be well aware of his biases and take rational decisions.

The wise old man, Warren Buffett said, “The most important quality for an investor is temperament not intellect."