Behavioral finance is the study of the application of psychology in the world of finance, especially in aligning differences between rational valuations and irrational market prices. These are the seven major behavioral biases that occur among retail investors. Don’t be ashamed to admit that you experienced it as a stock investor.
- Full of Yourself
Retail investors often overestimate their abilities. As a result of this bias, investors do not hesitate to transact stocks with margin facilities. This illusion of control also makes many investors trade actively because they feel they are able to control the market and predict the movement of future prices. What happens is often the other way around.
Another implication of this overconfident bias is the non-diversification practice of most retail investors in our exchange and in other world exchanges. In fact, being focused is not the right strategy for retail investors with average investment abilities.
- Representativeness
Many investors, especially beginners, cannot tell the difference between good stocks and good companies. They rate stocks as good or bad based on how good or bad the company is. Good stocks are not the same as good companies. If a good company already has a high price, the stock is no longer good.
This bias is related to the human phenomenon that often makes decisions based on stereotypes or from unrepresentative samples. Many of us encounter examples of this bias in everyday life. Applicants with a low GPA are considered to have poor performance at work, so they are not allowed to apply with a minimum GPA required.
An example of drawing conclusions from an unrepresentative sample is the statement from our Coordinating Minister and also from the executive of the Corruption Eradication Commission who said, “86% of the corruptors arrested were university graduates.” Those who can become corruptors are officials. Those entrusted to serve the position are also university graduates. Therefore, if this statement is continued, we will come to another wrong conclusion that no corruptors have been caught who are only graduates from junior high school.
- Confirmation
Humans generally want to hear or read what they expect and ignore what is not in accordance with their views. We feel annoyed by individuals, groups, and news sources with differing viewpoints. This also happens to investors. When we like and buy stocks, we will be happy to hear analysts or the media recommend these stocks. On the other hand, we tend to ignore anyone’s analysis from anywhere that says this stock is overpriced and it’s time to sell.
Now, let’s assume that we just sold that stock. We will smile with pleasure if we hear or read anyone who recommends selling for that stock because their views correspond to our opinion. We don’t like it when someone still recommends buying the stock.
- Mental Accounting
Many of us treat money from bet triumphs, bonuses or religious holiday allowance, and monthly salaries differently. We create separate accounts for the three in our minds, which are current income, current assets, and future income. We are willing to spend our current income but refrain from using future income.
Investors also view the benefits of dividends and capital gains differently. We do not hesitate to use the profits from dividends but are not willing to realize capital gains for consumption. This is because investors are afraid of regret (regress aversion) when some of the shares they have sold go up.
- Reference Price
This bias relates to the use of certain references for decision-making. If you sold a stock for Rp1,700 a few days ago, you may not be willing to buy it back when the price goes up to Rp2,000. You will always remember Rp1,700 as a reference for your decision to buy those shares.
There are also investors who use the minimum stock price for the past year as a reference for buying shares and the highest price as a reference for the selling price. If this happened, they would almost certainly never buy or sell the stock. What often happens is that investors use the purchase price as a reference (anchoring) the minimum price to sell it.
- Fear of Loss
Traditional investment books say investors are risk-averse. Risk is defined as price volatility. Behavioral finance has another view that investors are not actually afraid of risk but are afraid of loss or loss aversion.
Do you know the hope of an investor whose stock price drops shortly after he buys? His hope was not to make a profit, but he expect not to lose. Therefore his wish is that the price will return soon, so he can sell it and return on investment. This bias is also called the get-even-itis bias.
- Disposition Effect
The implication of loss aversion, get-even-itis, and regret aversion above is that retail investors often let their portfolio losses continue to flow. On the other hand, investors are quick to decide to sell shares at a profit. Instead of limiting losses and letting profits run, many retail investors actually do the opposite, limiting profits and letting losses accumulate.
Shefrin and Statman (1985) noted this as a disposition effect, which is selling the winners too soon and holding the losers too long. That would be all and Happy New Year 2023 to loyal readers of this column.
By: Prof. Dr. Budi Frensidy, S.E., M.Com., Professor of the Faculty of Economics and Business, Universitas Indonesia (FEB UI)
Source: Kontan Newspaper. Edition: Monday, January 9, 2023. Rubrik Portofolio – Wake Up Call. Page 4.
