It is said that financial market or stock market is risky. But what are the factors that make it so? Sudden market changes are no doubt one of the obvious reason, but there is one another reason that is hardly focused upon. This is the behavioral biases in individuals. Behavior prejudices affects the questions of risk versus return that investors frame in their mind. Perceptive biases like overconfidence, overreaction, and information bias creates imperfection in the financial markets.
“.. the market frequently mispriced stocks. This mispricing was most often caused by human emotions of fear and greed. At the height of optimism, greed moved stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moved prices below intrinsic value, creating an undervalued market.” — Robert G. Hagstrom, “The Warren Buffett Way”
Some common behavioral biases that create a negative impact on the decision making capability during long term investmentin stocks includes:
Overconfidence can over rate one’s own abilities. It is a pervasive tendency of human nature that they think they know more than others and this leads to disasters. Same is the case with the overconfident investors as they make insensitive choices & affect other market participants too.
For instance: Suppose the price of the stock in which they have recently made investment goes up. The overconfident investors make an opinion of having good judgment skills. In case of further price rise, a pattern of price increases is detected that results into more buying of same shares. This sometime proves negative and calls losses instead of profit.
- Overreaction Bias
Overreaction upon both good and bad news is disappointing. Suppose the quarterly results of the company are not as expected, then typical investor would sell all their shares before understanding the reasons behind it. The stock price gets majorly affected due to this.
- Confirmation Bias
Many investors consider the information or details only that match up with their existing beliefs. They tend to ignore any contrary information.
- Mental Accounting
Prospective losses sometimes bring more discouragement for the investors on compared to equivalent gains.
- Availability bias
Recent, well-publicized, traumatic, & vivid circumstances or events are given more weightage. Investors give more preference to blue chips stocks or the growth stock instead of the stocks with less media attention.
These are certain psychological components, which majorly influence individual investors’ trading behavior in the stock market.