Sunday, 24 June 2012
Factors influencing Decisions: A Quest for the proper course of Decision-making in Share-investments
It has been seen for a long time that human being is not always rational and his decisions are not always objective. For instance, if one watches share market, technically the price of a stock should be reflection of its P/E, P/CF & P/BV values, but such is not the case most of times, because the prices of indices are also governed by various aspect and factors of human mindset- expectations, sentiments and excitement to name a few.
This unpredictability of human behavior has led to emergence of a new field in psychology termed as ‘Behavioral Finance’. Behavioral Finance is the study of roles of behavioral factors in the field of finance, especially investment
It is well-known fact that intelligence is one of the important factors, besides hard work and perseverance for achieving success in life. It is generally expected from an intelligent individual to perceive and understand situation properly, think rationally and reason out everything, before making any decision. Clarity of goal, a well-thought strategy to achieve the same, moderate level of motivation, a disciplined behavior with flexibility to reassess the strategies with new developments is certain other requirements to achieve success. This is applied everywhere, in all decisions and goals including individual’s investment decisions as well.
But since human beings do not live in isolation, therefore there are other factors as well which influence his interpersonal relations, and consequently his decisions. Rationality in a man’s decisions or behavior is not always seen as to be expected from them. For instance, people do make different decisions in the two similar situations or behave similarly in two different situations depending upon their emotive state of mind. Thus, emotion plays a vital role in influencing his behavior and decisions. This becomes more apparent in case of investment-related decisions when taken in relation to the share market.
But debate does not end just here. Human beings are not just born for investment; they have other things to do as well. There are numerous occasions when people make mistakes in investment-decisions mostly under the influence of emotions and stress. It is not possible for a person to be totally immune to his emotions, but once he is aware of the risks involved with emotional instability, one can limit the losses. In this context, fear and greed are the most well-known emotions. There is tendency in human-beings to make more money in short time and this tends him to invest in share-market, even when it is at boom. So when market is bearish, the emotion of fear replaces greed. Human-beings love profit, but hate loss even more. A slightly negative indication brings in a lot of negative emotions and consequently, fear comes in. Initially, investor holds position (while rationally, if he wants to quit, he should book losses at that time only) and once the market’s bottoming out tendency to quit gets bigger (though if investor has been rational, he should have waited for a little longer duration and should have stuck to his position). In this way, it would not be wrong to say that not only fear and greed have negative effect on rational thinking, but they also have adverse effects on the long-term strategies of individual. These two unfortunate passions bring in impulsiveness in the individual’s character and continue to press him to take irrational decisions.
Further, Defense-mechanism of denial used by a person to save his self esteem and his ego are also significant factors which prove dangerous in the long run. An investor is, most of the times, adamant to accept that he has made wrong decision. So, he sticks to his decision and end up holding his loosing position longer than what should have been. The anticipation of ‘being wrong’ by any investor, cuts his losses and enables him to take decisions which help him to recover the loss.
Another aspect of Defense-mechanism of denial is its effect on analytical reasoning. Under emotional state of denial, an individual perceives selectively. He tends to emphasize data and information which confirm his position and viewpoint. It also restricts the individual to rationally analyze any new adverse information. Sometimes, it also generates tendency to overemphasize any subtle good indicator and underemphasize the bad indicators, and so, compel the investor to continue with the loosing position, thus aggravating loses.
These factors always influence the decisions of an individual, but the degree of their influence differs. Now, it depends on the individual how he (or she) manipulates these factors for profit. A good investor is one who not only comes out of loss by applying logical thinking but also makes it profitable one. Moreover, one should not stick to his decisions, if situations have changed. The people with low self-esteem and low EQ stick with their decision and apply defense mechanism. False impression of hope leads them to further losses. They even set aside the direction of necessary indicators.
So, to be a good investor, the proper way to act is not simply to book profit at appropriate time, but also to minimize losses in the adverse situations.
’Never Say Die’