Some practical examples of Behavioural Finance

Some practical examples of Behavioural Finance will show a different aspect - more from the psychological point of view - at how and why investors buy and sell stocks. It goes against the grain of Efficient Market theory that is built upon rational decision making taking into account all available information.

One of the interesting advantages of writing a blog is that readers get an opportunity to react almost immediately and let the writer know what they think about his opinions. Thereby opening a direct window to the workings of their minds.

In a recent post, I had suggested that investors should bail out of the telecom sector stocks, instead of jumping in after the price correction. In another post, I suggested investors should sell the Punj Lloyd stock at every rise, after it posted awful Q2 '09 results.

The reactions were swift. While some agreed with my views, many did not. The arguments were strong and apparently 'rational'. But what about investment behaviour?

"Bharti Airtel is the best in customer service, has a pan-Indian network, is a leader with a stash of cash, will be less affected by the price war and number portability. So, the stock was a 'steal' at 350 and more should be bought if it slipped below."

Why 350? Because it was 30% lower than its recent high of 500? Possibly. The human mind likes to work with nice round numbers. A classic example of 'recency bias' in Behavioural Finance. The price of 500 had remained in the investor's mind as a 'recent high'.

A few more readers thought 350 was a good price to enter. An example of 'confirmation bias' - investors looking for confirmation of a 'buy' decision. What happened when the stock dropped to 340?

"I sold at 340 so that I can buy it back at 325", was one comment. An example of 'loss aversion'. This is one of the most insidious biases for long-term investment success. Instead of admitting a mistake and booking the small loss, an investor tries to take on additional risk to avert the loss.

I'm not sure what this particular investor did when the Bharti Airtel stock first fell to 325 and then went below 300.

A comment about Punj Lloyd was:

"I sold the stock at 290 and was happy to buy it back at 240. Will buy more if it goes further down. The company has a huge order book, has global operations and is a Larsen and Toubro in the making."

Now that the stock has dropped below 200, 'Regret theory' in Behavioural Finance suggests that the investor has probably avoided selling the stock and is holding on to it to avoid the regret of making a bad decision.

'Prospect theory' in Behavioural Finance postulates that investors behave differently in situations depending on whether they are faced with a loss or a gain. They feel more pain at the prospect of losses than they feel elated by an equivalent gain. In other words, a 10 point loss in a stock costing 100 may cause more distress, than a 10 point gain causes happiness.

In actual experiments with different groups of investors, when evaluating the prospect of a sure gain, most investors become risk-averse; but faced with sure loss, they become risk-takers.

No wonder, Benjamin Graham has written: "The investor's chief problem - and even his worst enemy - is likely to be himself."