Behavioural finance lies at the heart of the theory of investor rationality. This implicitly challenges traditional economic models by considering human emotions at play. Understanding how you make investment decisions tells about the dynamics of financial markets.
Karl R. Popper, one of the world’s most influential philosophers stated the principle of rational thought. This law of rationality assumes that a person is a rational agent, trying to make optimal choices given the available resources and information.
Rational thinking is basically a process of weighing your pros and cons. You consider potential consequences and using systematic methods, you arrive at conclusions. It is used in studies where critical thinking and problem-solving are used.
What is Investor Rationality?
It is an assumption made by economists that all investors use logic and reason to invest in funds. It explains that all people are perfectly rational because they are self-interested. This theory assumes that everyone has access to complete and accurate information and can process it without emotional biases.
A rational investor will research and analyse various stocks. He/She would consider factors like financial health, market trends and economic indicators before making an investment choice. They will use this data to make decisions that align with their financial goals and risk tolerance, rather than making impulsive choices based on rumours or emotional reactions to market fluctuations.
But this is almost never true. Investors are not always driven by data or logical analysis. Emotions can play a significant role when it comes to life decisions, especially relating to money.. Different biases can lead you, as an investor to make decisions that are not in line with rational investment strategies.
Rational Decision-Making
On paper, we assume that there is access to all relevant information. In reality, investors often make decisions with incomplete or imperfect information. This can lead to irrational choices. Moreover, the volume and complexity of financial data can easily overwhelm you, even as a diligent investor.
Types of Investors Based on Investing Behaviour
There are two main types of investors in this respect – Overconfident and Status Quo Investors.
Overconfident investors have a high degree of confidence in their ability to research and predict market movements. So, they tend to be more active in risky behaviour like trading. Hence, they end up with high trading costs and trading-related losses. (SEBI report on trading losses)
On the other hand, status quo investors stick with their existing investments and strategies. This behaviour acts as a bias and leads to a lack of attention to portfolio management.
The key is to find an appropriate balance between the two kinds of investors.
Common Biases
Here are some of the common biases that investors succumb to:
- Loss Aversion
It is the tendency to feel the pain of a loss more strongly than the pleasure of an equivalent gain. Simply speaking, investors may hold onto losing investments longer than they should, hoping to avoid realizing a loss or sell winning investments too early to lock in gains.
- Confirmation Bias
This is the tendency to understand the information in a way that confirms pre-existing beliefs. So, investors may ignore evidence contradicting their investment beliefs and seek information supporting their views.
- Overconfidence
Overconfidence bias makes investors overestimate their knowledge, skills, and ability to predict market movements. They may trade excessively, take on too much risk, or underestimate potential losses.
- Herding Behaviour
This tendency to follow the actions of others, even if those actions are irrational, leads investors to buy assets simply because others are buying them.
- Anchoring
Anchoring bias refers to the tendency to depend too much on the first piece of information received, even if it is irrelevant. For example, investors might fixate on a stock’s historical price or a target return, even when market conditions have changed.
Strategies to Countereffect Irrational Behaviour
To counter such irrational behaviour, you, as an investor, must understand your own behavioural biases. It is important to set clear criteria for investment choices and exit strategies.
The most important part is to think long-term and diversify your asset classes. Long-term will help you avoid market fluctuations. And diversifying your portfolio is a great way to get through market risk. One of the ways to do this is by investing in mutual funds, a pool of stocks, bonds and other securities.
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FAQS
What is the assumption of a rational investor?
A rational investor assumes that they make decisions based on rational analysis and sound reasoning. This includes considering factors such as risk and return, financial information and market trends to select investments that maximise financial returns. They do not let emotions or short-term market fluctuations influence their decisions and strive to see past immediate market fluctuations and take a long-term strategic approach to investing.
Is the investor always rational?
The concept of rationality can be applied to investors in the context of their decision-making behaviour. However, it is important to note that people are not always rational, and this includes investors as well. Rationality refers to the use of logic and objective reasoning to form decisions. In investing, this involves analysing information such as market trends, financial data and other relevant factors to make informed decisions. While it is reasonable to expect that investors may make rational decisions, it is not guaranteed. Factors such as emotions, beliefs, and personal biases can also influence investment decisions. Therefore, it is not accurate to say that all investors are always rational.
Are rational investors risk-averse?
Rational investors are generally risk-averse, as they seek to maximise their returns while minimising their risks. This means that they will typically avoid investing in high-risk assets or projects that have a high likelihood of failure. Instead, they will focus on investing in low-risk assets or industries that have a proven track record of success. Additionally, rational investors may also use risk management techniques, such as diversification, to further reduce their exposure to potential losses.
What is halo bias?
Halo bias refers to the tendency to overestimate the positive attributes of a person or entity based on their appearance or other superficial attributes. This bias can lead to irrational investment decisions. So, as an investor, you may be more likely to invest in companies or individuals that you perceive as attractive or successful, regardless of their actual financial performance. It is important for investors to be aware of halo bias and to avoid making investment decisions based solely on superficial factors. This is also known as halo effect.
What is a common bias?
A common bias is something that can influence our decisions and judgments. It is often unconscious and can affect you.
What are the most common behavioural biases?
Some of the most common behavioural biases include loss aversion, confirmation bias, overconfidence, anchoring bias, sunk cost fallacy, and herd mentality. These biases can lead to suboptimal outcomes. Hence, understanding these biases can help you make better investment choices.
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