The emotions behind investors’ actions are all too well-known: greed and fear. Greed drives investors to buy more during a bull market; whereas, fear becomes the driving force for them when the market is in a slump, making them get rid of assets. It is important to grasp how these emotions affect our thinking so that we act against our economic interests.

Decision-Making under Risk
When faced with risks, fear of loss and desire for gain greatly influence our decisions. These emotions can cloud your judgement and lead to irrational choices.

Prospect Theory: A Key Concept in Behavioural Economics

Behavioural economics has Prospect Theory at its foundation which was developed by Daniel Kahneman and Amos Tversky. This theory explains how people make choices when they face uncertainty. The theory demonstrates that people do not attach equal weights to gains or losses leading to two major behavioural anomalies: Loss Aversion and Sunk Cost Fallacy.

Loss Aversion: Fear of Losing

This is an unwillingness to accept equivalent gains instead of avoiding losses. The displeasure felt from losing something is twice as intense as the happiness experienced from gaining the same thing back again. These fears lead to some counterproductive behaviours:

Preferring Fixed Income Investments: Following significant losses such as those experienced during the dot-com bubble burst, many investors abandoned stocks and opted for fixed-income investments because they were seen as being safe.

Taking Profits Too Early: Investors usually sell their profitable holdings too soon due to their apprehension about losing those gains made thus far resulting in small profits instead of larger ones that could have been realised had they stayed longer.

Taking More Risks When Facing Losses: Instead of cutting their losses, investors tend to take even more risk hoping to recover what they have lost rather than accepting that it is gone forever.

Example: Loss Aversion in Action

Suppose you have been given Rs. 5,000 and there are two options:

Option A: Guaranteed loss of Rs. 800.

Option B: If the coin flips heads, you lose nothing; if it lands tails, however, you lose Rs 2,000.

Most people would choose Option B despite the possibility of higher losses in comparison to the certainty of Option A’s loss because we hate any form of guaranteed loss. This shows how people willingly take on more risk to avoid some specific losses.

Sunk Cost Fallacy: Inability to Forget Past Costs

In this context, sunk cost fallacy refers to our habit of continuing with what we had started simply because we have already invested resources in it (time, money or effort) irrespective of its current costs and benefits. It is driven by our desire to rationalise earlier decisions and reluctance to admit making an error. 

Example: Sunk Cost Fallacy in Investing

You bought a stock at Rs. 600 based on your friend’s advice but it shot up to Rs. 1,000 before declining dramatically to Rs. 150 per share. You decide that you should buy more shares to reduce the average cost per share. However, if this decision is motivated mainly by a need to break even rather than by your conviction that performance will improve then sunk cost fallacy has caught up with you.

How Emotions Influence Market Behavior

Risk Perception and Market Experience

Your first involvement in the stock market shapes your perception of risk a lot. For instance, if you began investing during a bull period, you might tend to be more supportive of risk. On the other hand, if you started just before the 2008 crash, for instance, it might be hard for you to take risky bets in your portfolio.

Behavioural Patterns in Investing

Loss aversion and Sunk Cost Fallacy are two factors that often lead investors into particular ways of behaving:

Preferring Fixed Income Over Stocks:

After significant market losses, many investors shift their focus to safer investments.

Early Profit-Taking: Fear of losing small gains leads to selling winners too early.

Risky Behaviour Under Loss: Facing losses, investors might take on more risk in an attempt to recover.

Tax Aversion: Another Form of Loss Aversion

Taxes are generally seen by people as loss and are therefore avoided at all costs which can sometimes result in suboptimal financial decisions being made in return for this avoidance. Changing your mindset to view income net of taxes can help mitigate this bias.

Are You a Victim of Loss Aversion or the Sunk Cost Fallacy?

You can find out whether these two biases influence your decision-making by asking yourself some questions such as;

Would you rather have fixed-income securities than stock?

Is there any temptation inside you that surfaces when prices fall?

Is your portfolio generally composed with very few winners compared with numerous losers?

Do you usually let go off winners quickly but keep many losers till long after they have lost their value?

Will historical expenditure affect current spending?

In case you say yes to the above questions, you might be experiencing Loss Aversion or the Sunk Cost Fallacy.

Here is an additional list of biases that you should be aware of,

Status Quo Bias: Resistance to Change

Status Quo Bias is our preference for the current state of affairs. We do not like change and we prefer things just as they are. Because of this bias, many opportunities may pass us by and there may not be enough diversification in our investments.

Availability Bias: The Ease of Recall

Availability Bias happens when we estimate how often something will happen because it reminds us of something else similar, we have recently experienced. Something that has happened more frequently therefore is perceived as having a higher probability than what can hardly be remembered at all. This bias can lead to overestimation of the likelihood of very extreme events which are also widely reported by media houses.

For example, in such cases where negative news causes a stock’s value to drop drastically, investors may take about three months before investing in it again.

Confirmation Bias: Seeking Affirmation

Confirmation Bias is the tendency to search for, interpret, and remember information in a way that confirms one’s preexisting beliefs. Sometimes people disregard or underemphasize any ideas which are selected against their own values. This bias can lead to reinforcing existing beliefs while ignoring evidence that could lead to better decisions.

Illusion of Control Bias: Overestimating Influence

The Illusion of Control Bias happens when people believe they can control or influence outcomes that they actually cannot. As a result, traders become overly confident while taking on excessive risks since they think they have mastered every trading scenario.

Anchoring Bias: Sticking to Initial Values

People do tend to rely heavily on the initial information or anchor when making decisions, which is referred to as anchoring bias. Simply put, individuals are poor estimators of values in situations where the magnitude is unknown; they will often start with an arbitrary number and adjust from there. This can make for incorrect evaluations and predictions.

Mental Accounting Bias: Segregating Money

The mental accounting bias entails treating one sum of money differently from another even if they are equal in amount based on what account it falls into. For example, people differentiate between income returns and capital gains irrationally. While most people would be willing to spend all their investment returns, requiring them to preserve their principal, this kind of thinking may result in inefficiency among individuals who need sound financial judgments.

Overcoming Behavioural Biases

Diversification and Portfolio View

If you look at your investments as a part of a diversified portfolio rather than separately it helps overcome these biases. A case in point is where 5 out of 20 stocks lose 30% each; however, it will only lead to a loss of 7.5% for the whole portfolio. Viewing losses this way can reduce the emotional impact and help you make more rational decisions.

Developing a Rational Investment Strategy

Establish a clear investment strategy based on research and long-term goals. Regularly review and adjust your portfolio to align with these goals, rather than reacting to short-term market fluctuations.

Mindfulness and Education

Be mindful of your emotions and biases when making financial decisions. Educating yourself about behavioural finance can help you recognize and mitigate these biases.

Conclusion

Understanding the impact of greed and fear on our financial decisions is crucial for becoming a more rational investor. By recognizing and addressing behavioural biases like Loss Aversion and the Sunk Cost Fallacy, we can make more informed and beneficial financial choices. 

Remember, the key to successful investing is maintaining a long-term perspective and not letting emotions dictate your actions.