Human beings are said to rational animals, but when it comes to earning money we have been irrational and this has led to a lot of mistakes. Mistakes have been part and parcel of our daily life. Sometimes we learn from these mistakes, some we ignore and some are not even known to us. Stock markets are also not free from mistakes. Investors make mistakes regarding when to buy a stock, price of the stock, holding period of a stock, and even end up buying wrong stocks. In stock market we call these ‘mistakes’ observational errors. Observational error refers to the difference between a measured value and its true value. Since these mistakes are caused due to the various emotions of an investor there is a need to understand how and why emotions and even cognitive distortions influence investors. Behavioral Finance serves this need. Behavioral finance is primarily concerned to the rationality of investors.
The whole stock market runs on two basic principles – Demand & Supply. The introduction of a third principle of market sentiments triggered the study on how these emotions would affect the working of stock markets. As the old saying goes ‘Stock markets are driven by two powerful emotions – greed and fear’. These two emotions if unchecked influences the decisions of investors and they tend to make mistakes and in extreme cases leads to bubbles and crashes. These extreme urges in investors have led to numerous reactions like herding, overconfidence, confirmation bias, noise trading etc. Other observations of behavioral finance include ‘bird in the bush paradox’ and loss aversion. Behavioral finance attempts to fill the void and explore the relationships among these factors.
This takes me to our title ‘Why smart people make big money mistakes?’ why they commit these mistakes even after these are pointed out to them in the first place?. The answer to this is that emotions have better hold on humans than actual facts or data.
Warren Buffet once said “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ…Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” The trouble that Mr. Buffet was talking about is only caused by sentiments. Control them investors are going back home with cash.
This blog is written by Salman Shiras, student of MBA-FA 2015-17 batch, ICoFP Delhi Campus.