Unit 4: Investor Behaviour
Investor Behaviour
Investor behaviour studies how real investors make decisions, which is often different from what traditional finance assumes.
Traditional finance says investors are:
- rational
- risk-averse
- wealth-maximizing
Behavioural finance argues that real investors are influenced by:
- emotions
- biases
- shortcuts (heuristics)
- psychological needs
- social pressure
1. Portrait of an Individual Investor
A typical individual investor:
A. Psychological Traits
- Seeks safety but also wants high returns
- Has fear of loss
- Overreacts to market news
- Feels regret after losses
- Easily influenced by media, friends, trends
B. Investment Behaviour
- Buys high during hype (FOMO — fear of missing out)
- Sells low during panic
- Prefers familiar stocks (home bias)
- Trades too frequently
- Avoids complex financial products
- Holds losing stocks for too long (loss aversion)
C. Information Processing
Relies on:
- tips
- social media
- friends
- emotions
- Not always optimal or rational
Overall, an individual investor is not fully rational and is heavily influenced by psychology.
2. What Heuristics & Biases Mean for Financial Decision Making
Heuristics = mental shortcuts used to make quick decisions.
Biases = errors that arise from these shortcuts.
Key Biases & Their Effect on Investment Decisions
| Bias | Meaning | Impact on Investment |
|---|---|---|
| Overconfidence | Investors overestimate their knowledge | Excessive trading, higher losses |
| Anchoring | Giving too much weight to the first number seen | Holding stocks based on old prices |
| Representativeness | Judging based on stereotypes | Chasing recent performers |
| Availability Bias | Decisions driven by easily recalled information | Investing in popular/trending stocks |
| Loss Aversion | Losses hurt more than gains feel good | Holding losing stocks too long |
| Herding | Following the crowd | Buying at peak, selling at bottom |
| Confirmation Bias | Looking for information that supports own opinion | Ignoring negative signals |
Core Understanding
Heuristics simplify decisions but often lead to systematic errors → reducing returns and increasing risk.
3. Implications of Emotions
Emotions strongly influence investor decisions.
A. Fear
- Panic selling
- Avoiding good opportunities
- Investing in low-return safe assets
B. Greed
- Chasing high-risk, high-return stocks
- Entering bubbles
- Over-leveraging (taking too much debt)
C. Regret
- Not investing due to fear of making a mistake
- “I should have bought that stock” → emotional stress
D. Pride/Ego
- Not selling losing stocks
- Not admitting mistakes
Impact on Financial Decisions
- Emotional investing often leads to poor timing
- Investors buy/sell at the wrong time
- Emotional reactions reduce long-term wealth
4. Mental Accounting
Proposed by Richard Thaler, mental accounting means investors treat money differently depending on its source or purpose — even though money is fungible.
Examples
1.Treating salary money carefully but spending bonus casually.2. Keeping separate mental “buckets”:
- “Savings bucket”
- “Emergency bucket”
- “Investing bucket”
4. Selling winning stocks quickly (to book gains) but keeping losers (to avoid realizing losses)
Implications for Investment
- Leads to non-optimal diversification
- Increases risk in certain accounts
- Causes “house-money effect” — taking more risks with profits
Mental accounting helps investors feel comfortable emotionally but reduces logical decision quality.
5. Behavioural Portfolio Theory (BPT)
Proposed by Hersh Shefrin and Meir Statman, BPT is an alternative to Markowitz’s Modern Portfolio Theory.
Key Ideas of BPT
Investors structure their portfolios into multiple layers, each serving different goals.
Think of it like a pyramid:
Layer 1: Safety / Protection Layer (Bottom Layer)
- Very low-risk investments
- Purpose: not to lose money
- Examples: Fixed deposits, government bonds, emergency funds
This layer satisfies security needs.
Layer 2: Aspiration / Growth Layer (Upper Layers)
- Higher-risk investments
- Purpose: achieve high returns, dreams, or aspirations
- Examples: Equity, crypto, start-up investing
This layer satisfies aspirational goals.
Why BPT Differs from Traditional Finance
Traditional finance says:
- maximize return for a given risk
- consider whole portfolio as one unit
But BPT says:
- investors make separate “mental portfolios”
- they prefer safety + chance of jackpot, not optimal diversification
- emotions override rational calculations
Practical Implications of BPT
- Portfolios may be unbalanced
- Investors may mix safe assets with extremely risky assets
- High emotions influence asset allocation
- Diversification becomes weaker
Example: A person invests:
- 70% in FDs
- 30% in very risky small-cap stocks
This looks irrational mathematically, but psychologically satisfies both safety and aspiration goals.
Summary (For Exams)
| Topic | Key Points |
|---|---|
| Portrait of Investor | Emotional, avoids losses, influenced by media & trends, trades too much |
| Heuristics & Biases | Cause irrational decisions like overtrading, poor stock selection |
| Emotions | Fear & greed lead to buying high, selling low |
| Mental Accounting | Money treated in buckets → poor diversification |
| BPT | Investors build portfolios in layers: safety + aspiration |
Psychographic Models (Investor Personality Models)
Psychographic models classify investors based on psychological characteristics, risk attitudes, and decision-making styles. These models help understand why different investors behave differently even in the same market.
A. Barnewall Two-Way Model
Divides investors into two types:
1. Passive Investors
- Low risk-takers
- Prefer safety and stable returns
- Earned wealth (not self-made)
- More emotional security seeking
2. Active Investors
- High risk-takers
- Self-made wealth; confident
- Prefer control and decision-making
- More comfortable with volatility
B. Bailard–Biehl–Kaiser (BBK) Five-Way Model
Classifies investors along two dimensions:
- Confidence
- Method of action (careful vs. impulsive)
Types of Investors:
1. Adventurer- Confident + impulsive
- High risk, independent, aggressive
2. Celebrity
- Impulsive + unsure
- Easily influenced by trends and advisors
3. Individualist
- Confident + careful
- Rational, analytical, long-term investor
4. Guardian
- Careful + unsure
- Prefers safe investments, conservative
5. Straight Arrow
- Balanced and moderate
- Average risk tolerance, diversified portfolio
C. Myopic Loss-Aversion Model
- Investors focus too much on short-term losses
- Leads to fear-based decisions
- Reduces long-term wealth
D. Lifecycle (Age-Based) Model
Risk tolerance varies with age:
- Young investors → high risk
- Middle-aged → moderate risk
- Retired → low risk
Basic Ingredients of a Sound Investment Philosophy
A sound investment philosophy is a set of guiding principles that shape how an investor makes decisions.
A. Clear Understanding of Risk
- Know your risk tolerance
- Understand that higher returns = higher risk
B. Diversification
Spread investments across asset classes:- Equity
- Bonds
- Real estate
- Gold
- Reduces risk from any single asset
C. Long-Term Perspective
- Avoid short-term noise
- Stay invested during volatility
- Use systematic investing (SIP approach)
D. Behavioural Discipline
- Avoid emotional decisions
- Follow rules consistently
- Stick to strategy even during market stress
E. Research-Based Decision Making
- Study fundamentals
- Do not rely on rumors, tips, or trends
- Understand the business before investing
F. Margin of Safety (Benjamin Graham Principle)
- Buy securities below their intrinsic value
- Protects from downside risk
G. Consistent Review & Rebalancing
- Adjust portfolio according to changing goals
- Maintain target asset allocation
H. Simplicity
- Prefer simple, understandable strategies
- Avoid overly complex products unless knowledgeable
Guidelines for Overcoming Psychological Biases
Investors often commit errors due to cognitive and emotional biases.
Below are practical guidelines to overcome them.
A. For Overconfidence Bias
- Maintain a trading diary to track mistakes
- Limit number of trades
- Use data, not intuition
- Seek second opinions, especially from unbiased advisors
B. For Anchoring Bias
- Re-evaluate investments based on current information
- Do not fixate on purchase price
- Use valuation metrics instead of past prices
C. For Loss Aversion
- Accept that losses are part of investing
- Focus on long-term goals, not daily price movement
- Use SIP to reduce emotional impact
D. For Herd Behaviour
- Do independent research
- Avoid reacting to social media or news hype
- Ask: “If nobody else invested, would I still buy this?”
E. For Mental Accounting
- View all money and portfolios holistically
- Avoid excessive compartmentalization
- Use a single investment strategy for entire portfolio
F. For Confirmation Bias
- Look for evidence that disproves your view
- Read both positive and negative research reports
- Avoid echo chambers (friends/social media groups)
G. For Representativeness Bias
- Do not judge based on recent performance
- Evaluate long-term fundamentals and stability
H. For Emotional Biases (Fear & Greed)
- Automate investments (SIP, STP)
- Use stop-loss and target-setting
- Follow asset allocation instead of emotions
-
Set rules like: "I will not sell during panic unless fundamentals change."
Summary Table
| Topic | Key Points |
|---|---|
| Psychographic Models | Categorize investors by personality, risk, confidence & decision style |
| Investment Philosophy | Diversification, risk understanding, long-term view, research, discipline |
| Overcoming Biases | Use data, avoid emotions, seek contrary evidence, automate investing |