Tuesday, April 4, 2017

Stock Market Bias / Financial Behavior Patterns- Informed & Uninformed Investor

Stock market Biases:
Though both Informed and uninformed investors are supposed to take a rational approach when seeking to maximize their wealth through investments in stock markets yet this doesn’t happen in the real world. There are many instances where emotion and psychology influence the uninformed investor’s decisions causing them to behave in unpredictable or irrational ways. Behavioral finance seeks to explain the reason behind this irrational and illogical behaviors through cognitive psychology.

Cognitive Bias
Cognitive psychologists have documented many patterns on investor’s behavior. Some of them are:

Heuristics (Rule of thumb): When faced with N choices uninformed investors follow 1/N rule for fund allocation. This might lead to sub optimal investment decisions. for example, suppose there are 3 funds to invest, then people allocate 1/3 of the funds into each. In case there are two equity funds of the 3, then 2/3 of the allocation will be for equities.
Informed investors on the other hand identify the risks associated with fund and prefer diversifying the allocations based on the fund type.

Overconfidence: Uninformed investors get overconfident about their abilities and tend to invest too much amount in one company. Their portfolio gets less diversified and is therefore becomes a riskier investment.
Informed investors generally identify the risk associated with investments, they regularly go through the financial statements and management decisions and weigh their investment options.

Mental Accounting: Uninformed investors tend to separate their money into different accounts based on their usage. This behavior often leads to detrimental and irrational effect on their consumption behavior. An uninformed investor divide their portfolio into safe investment portfolio and speculative portfolio whereas on the other hand informed investor keeps the investment under one large portfolio and does not prefer separating accounts.

 Representativeness: While investing money in a share market, uninformed investor tend to give more weight-age to their recent experiences rather than looking at the stocks past performance. Though this can be a temporary effect due to market movement.
Informed investor does not go by the experiences, they wait for the right time and take stock positions based on their objective, term and priority.

Many a times uninformed investor have very strong preconceived notions about something and tend to follow prejudices while making the investment decisions:

Confirmation Bias: Uninformed Investor tend to search for the information that supports his original idea rather than searching the information that contradicts it. This type of selective thought process is confirmation bias.
Informed investors on the other hand perform detailed analysis on the company financials. Their decisions are based on the facts and figures without pre-conceived thoughts.

Gamblers’ Fallacy: The probability of market going up or down the next day is independent of the past events. Still uninformed investors presume based on the historical events that markets will fall on the sixth day if it has risen for the last five days and according places a short call in the market.
Informed investors take a call based on their objective, term and priority. They are not impacted by the temporary fluctuations in stock market.

Negativity Bias: The uninformed investors normally fear that the market will reverse the course and with the said fear they tend to shy away from stock market during initial phases of Bull Run. Negativity bias causes investors to put more weight on bad news than on good news.
Informed investors are sort of independent of the phases. They prefer buying more when the market is low and see if they have achieved their respective targets.

Bandwagon Effect: The uninformed investors buy the shares based on market commentary and other investor’s hearsay. They buy when the market is at its peak and they sell the stock when the market is at rock bottom. Informed investors normally prefer buying the stocks when markets is low and they prefer to sell when they have achieved their targets.

Emotional Bias
Though cognitive and emotional bias seem to overlap; emotional bias is taking actions based on feelings instead of facts. Here are few examples:

Loss-Aversion Bias: Uninformed investor prefer to hold the stock even though it has heavily depreciated in value. They are of conviction that one day the stock would turn into profit before they could sell it.
Informed investor on the other hand go by stop loss and sell the stocks if the share has depreciated by a certain value. They prefer re-investing the amount into some other good quality stocks.

Endowment Bias: An uninformed investor prefer to hold to hold the loss making stock just based on the fact that he is holding the best stock in the sector and the stock will rise one day.
Informed investor on the other hand moves to some better-quality stocks if the current holding stock does not show any sign of appreciation in its value.