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In our first article on behavioural finance, we explored four theories that shed light on what causes people to make irrational financial decisions. Now, we explain the remaining four concepts. A good understanding of these theories in their totality should give investors the information they need to avoid falling into their traps.
If you have ever separated your money into different accounts depending on its purpose, you have committed mental accounting. According to this theory, assigning different functions to each asset group based on arbitrary and often irrational reasons could have negative effects on a person’s consumption decisions and behaviour. Even something as harmless as a “vacation fund” can attest to this, as people are less likely to take money out of this fund to use it for more immediate needs such as paying off credit card debt.
In other words, the money in this fund is being treated differently, to the detriment of one’s net worth, which continues to fall thanks to the interest they accrue on their debt. The reason people continue to subscribe to this method is due to the personal sentiment they attach to those specific assets. Money saved for their children’s education or a new house seem too “important” to give up, even when doing so could improve the current state of their finances.
The winner’s curse is a tendency for the winning bid to exceed the actual value of the purchased item. This is usually due to two factors extrinsic to the core value of the item itself – the number of bidders and the aggression with which they bid. The more bidders there are, the more aggressive one has to be to get the item. However, increasing one’s aggressiveness also increases the chance of overpaying for said item. Sometimes, bidders also lack relevant information about the item being auctioned, and bidders who find it difficult to determine an item’s intrinsic value can end up overbidding.
One example of this happens when people are bidding for a house. The more bidders there are, the higher the perceived value of the house. Some of the bidders may know the house’s true value if they have inside information or did sufficient research, but some will end up overbidding because they got caught up in the bidding frenzy and did not have relevant information. Even if they manage to get the house, they may not be able to secure financing for it because the price they agreed to was too high.
Simply put, overreaction occurs in financial decisions because humans are emotional creatures. When new information about a commodity is released, investors tend to overreact by quickly buying or selling assets based on whether the information is positive or negative, respectively. Because of this, securities can become over- or undervalued within a short period of time before the market stabilises and investors realise that their behaviour was illogical.
As a result of their actions, the market trends get reversed – commodities that were originally undervalued tend to become winners when investors buy more on realising its potential, and vice versa. In this way, overreaction also gives way to availability bias, which states that recency of information is the prime factor contributing towards investment decisions.
Overreaction occurs in the day to day as well. Let’s say you witness a robbery on a particular street while walking to the train station one day. Even though logically you realise that this is probably a one-off occurrence that could have happened on any other street, you avoid walking through that one for the next few days because you perceive it to be more dangerous.
Researchers have found that even though the net effect of gains and losses associated with a particular choice should be equal, it is not so. Technically, the way you would feel if you have been given $50 should be the same as if you were given $100 and lost $50 since the net amount of both scenarios is a gain of $50. But in reality, you would feel much worse about getting the $100 and then having $50 taken away.
Prospect theory is commonly used to explain quite a few irrational financial decisions. It explains why investors tend to sell winning stock too soon and hold on to losing stocks for too long. The potential gains outweigh the losses, even though logically an investor should hold on to winning stocks to sell at a higher price and get rid of losing stocks as soon as possible. One way to avoid this trap is to break down potential losses into smaller chunks to be able to frame the situation into separate gains and losses.
Most of us have been guilty of making some, if not all of these assumptions at some point in our saving or investing journey, or while simply going about our daily lives. Fortunately, it is never too late to educate ourselves and become more aware of how to make better, and more logical financial decisions.