Psychological traps affecting stock market investing

Introduction

“We are our own worst enemies, for the mindless decisions we make, as well as our frequent inability to learn from them.” Nowhere is this more evident than in the stock markets, where this enemy from within us has a way of making us too confident, too timid, too impulsive, and too staid - sometimes even all at once.

Bullish Market Investor is hopeful

Bearish Market Investor is fearful

Major Emotions driving Investors

FEAR HOPE

Psychological Traps

Heuristic - Driven Biases

• Heuristic learning process is one in which people develop investment decision making rules through experiment, trial and error or personal experience.

• Rather than research investment ; individuals form investment rules and make investments using information that is most prominent in the media or otherwise most readily available

Heuristic driven Biases

Representatives

Overconfidence

Anchoring and Adjustment

Aversion to ambiguity

Heuristic - Driven Biases

Representatives• In this type of bias, investors base expectations upon past experience by

applying stereotypes

Example: • An investor might feel that all firms with management espousing

environmental awareness are good firms

Drawback• In this type of bias the investor applies" if then heuristic" that is if this

happens than the other thing will happen.

• As it is just based on thumb rule; it can give bad investment results

Heuristic - Driven Biases

Overconfidence• Overconfidence is when individuals are too confident in their ability to

predict

Drawback• Overconfidence can lead to increased trading and less portfolio

diversification

• It can also lead to surprises since the investor continuously underestimates the range of possible returns

Anchoring and Adjustment

• It refers to the inability to fully incorporate the impact of new information on projections

Example• An analyst may have already made a forecast for the performance of a

stock, when the firm releases new information that can have a material effect on the stock price

• The analyst being anchored by his prior projection will tend to not fully reflect the full value of the new information in his revised projections

Heuristic - Driven Biases

Psychological Traps

Frame dependence• Frame dependence implies that individuals make decisions and take

actions according to the framework within which information is received or the individual's circumstances at that time

Loss aversion

• It refers to the individual's reluctance to accept losses

• A stock may be down considerably from its purchase price, but investor holds on to it, hoping that it will recover

• You can relate this to a gambler who keeps throwing the dice, hoping to break even

Psychological Traps

Self control• Self control that is controlling one's emotions is related to frame

dependence

Example• Consider a stage of life and dividends

• A younger, affluent investor may totally avoid high dividend paying stock because of the related tax consequences and the effect on portfolio return thus this can create bias in the long term

Psychological Traps

Regret minimization• Regret is the feeling associated with making a bad decision. The investor

starts thinking, "if only I had.."

Example• After selling winning stock ,and then watching it soar even higher, the

investor starts thinking, "if only I had held on a little longer"

• Alternatively, the same investor after holding onto the stock and watching it fall back, might say," if only I had sold the stock last week"

Drawbacks• To avoid the possibilities of regret ;investors tend to stay in comfortable

investments like bonds and defensive stocks and hold on to looser investments for too long

Psychological Traps

Money illusion

• Money illusion refers to the way individuals react to inflation and its impact on investment returns

• People mostly think in nominal terms without any regard to inflation and its effects this can lead to a wrong mean variance analysis

Psychological Traps

• Psychological traps can lead to biases while making investment decisions

• So the investors must base their investment and trading decisions on rational mean variance analysis and risk return profile rather on rules based on experience and trial and error because it can lead to losses in the long term

Conclusion

Thank You!

And give us your Feedback

OR

If you have any questions click on any of these -

Read More

• Registered office: Kotak Securities Limited, 1st Floor, Bakhtawar, 229,

Nariman Point, Mumbai - 400021. SEBI Registration No: NSE INB/INF/INE

230808130, BSE INB 010808153/INF 011133230/INE 011207251, OTC

INB 200808136, MCXSX INE 260808130.

• Disclaimer: Investments in securities are subject to market risks, please

read the SEBI prescribed Combined RDD prior to investing.

• * Awarded Best Brokerage Firm in India by AsiaMoney in 2006, 2007, 2008

and 2009