The Behavioural Gap - Why Investors Do Not Get The Returns They Should?
Two investors, Mr Gupta and Mr Khanna, both invest in the same mutual funds. They have access to the same information, face similar market conditions, and hope to earn substantial returns.
However, when they review their investment performance after a year, Mr Gupta finds himself disappointed with minimal gains, while Mr Khanna celebrates impressive profits. What could explain this stark difference? The answer lies in the intriguing world of investor behaviour.
Have you ever wondered why investors often fall short of their expected returns or struggle to outperform the market? This is not because the markets are inherently unfair or random; rather, it's the investors’ behavioural biases and emotional tendencies that influence their decision-making process. Understanding and addressing these behavioural gaps is crucial for investors seeking to maximise their returns.
Many variables influence investors to make irrational judgements that may not be in their best interests. People are motivated by emotions such as greed, fear, anxiety, and excitement. Most individuals are victims of 'Herd Behavior,' which means they mimic the actions of other investors in the market, creating stock market rallies and bulk selling.
Investors are notoriously cautious when it comes to their finances. Investors, in general, are loss averse and strive to maximise their profits while minimising the risk on their investments. Despite such clarity in the investment objective, they tend to make irrational decisions based on certain psychological factors. They would be willing to trust unauthentic information if it meant a better chance of profit. At such times, they would abandon all rational theories and calculations and would assume higher risks to satisfy their greed.
When we go shopping, we anticipate the greatest prices and prefer to get items at a discount. If something we want to buy is priced at Rs 100, but we can get it for Rs 90 because of a sale, we would rather pay less and get it at a discount. The same should be true for the stock markets. People are afraid to buy when the markets are selling at a discount. When stock markets rise, investors rush to buy despite the premium prices. Such was the tech bubble of 2000. People were optimistic about technology, which encouraged investments in internet-based businesses in the 1990s. The 'greed' and 'herd behaviour' of ordinary investors encouraged them to acquire more and more ownership of internet-based enterprises. As a result, stock prices increased and skyrocketed. However, the market began to correct in the 2000s, and the bubble burst. This had an effect up to the 2002 bear market.
Investors are biased when it comes to market information and news updates and make judgements based on these biases. These biases include :
- Experiential/Recency Bias - Refers to the bias of investors towards their experiences of events that have occurred in the recent past. Investors start believing that the probability of the event that happened recently is highly probable to occur again and hence, rush to make rash decisions.
For instance, when there is a correction in the market, like the one post the burst of the housing bubble in 2008-09, many investors, based on their recent experience, believed that investing in the markets is more likely to cause losses than profits and hence abandoned the market. However, the markets did recover, and the economy blossomed again.
- Familiarity Bias - This bias highlights the tendency of investors to stick to investing in something they already have knowledge about or have a history with, bringing about a lack of diversification in their portfolios and hence increasing the risk. This can have various underlying reasons, such as industry, management team, operating sectors etc.
- Loss aversion - Loss aversion is a behavioural bias where individuals feel the pain of losses more strongly than the pleasure of equivalent gains, leading to a tendency to avoid or minimize losses at the expense of potential gains.
- Confirmation Bias - This bias refers to the investors' behaviour of not only confirming and accepting but, in fact, actively finding information that aligns with their preconceived notions and beliefs. Due to such preconceived notions, investors might miss opportunities due to clinging to the information they are comfortable with.
- Mental Accounting - Mental accounting is a cognitive bias where individuals segregate money based on subjective factors, leading to irrational decisions. For instance, people may spend windfall gains on luxury items instead of investing, as they mentally assign it to a "fun" account rather than savings or investments.
Other common biases include herd mentality, greed and fear which we have talked about before. To overcome these emotions and mental biases, investors can follow these steps -
- Education and self-awareness - Investors need to educate themselves about behavioural biases. By understanding these tendencies, they can recognise when emotions are influencing their decisions and take steps to mitigate their impact. Increasing self-awareness allows investors to align their investment strategies with their long-term needs and risk profile.
- Need-based investing - When investors formulate long-term financial needs that are specific and quantifiable, they are more likely to stay on track. A solid plan would help investors avoid impulsive decisions driven by short-term market fluctuations and provides a roadmap to fulfil financial needs.
- Seeking guidance from a mutual fund distributor - A mutual fund distributor can hand-hold the investor during cycles of market volatility. Mutual fund distributors can help investors navigate through their emotional biases and guide them to make rational and informed decisions.
- Regular review and rebalancing - Investors should regularly review their portfolios to ensure that their investments remain aligned with their financial needs. Through rebalancing, they can adjust portfolio holdings to maintain the desired asset allocation. This disciplined approach helps investors avoid being influenced by short-term market movements and brings their portfolios back in line with their long-term needs.
To conclude, the behavioural gap is often responsible for investors not achieving the returns they deserve. Investors can often fall prey to their emotions; however, it is important to navigate through these emotions and make the right choices in order to get the best returns. This highlights the importance of understanding and addressing the emotional biases that influence investment decisions. While markets can be unpredictable, it is the behavioural tendencies of investors that often hinder their ability to maximise returns.