Do you regret that you have sold a profit making stock too early?
Have you ever wondered what is going wrong immediately after you book profit making stock bought for the purpose of investment?
Have you been wondering that you act differently when you are behind the trading system?
Research says things that investing models do not align with investor behavior.
You are no different when you are taking these decisions. Even the most passive investors are at the time forced to take such decisions and later regret the same.
More evident in active investing especially the pressure of transaction costs drag down on the returns earned by the investors.
Investing with limited activity is rarely found. Since it is not human nature to earn without doing anything. It has been part of our thinking from ages that we cannot earn without doing anything.
Behavioral finance has got most of the answers.
Our behavior during the situation of Mental accounting and Risk calculation works in a different way.
Our calculations are worked in a very different manner. The probability of loss is worked out differently when compared to the probability of profit.
Here is an interesting Video on Disposition Effect as given Lecture at Northeastern University.
THE PROPENSITY EFFECT
The Propensity Effect: Selling Winners and Holding Losers – This is a direct effect of Prospect theory for which the chart is attached below.
More details on Prospect theory can be read here.
This will give a better Idea on how people manage Risk and Uncertainty.
This bridges the gap between the finance and psychology.
DECISION MAKING DURING THE EVENT
Now the entire situation can be broadly classified into which is rational and irrational decision making.
The entire process in which the investor uses all the information available and include the information in the decision making leads to a rational decision.
When the information available to him is ignored and uses his own mind in decision making leads to irrational decision making.
OBJECTIVES OF BEHAVIORAL FINANCE
- Ideal Decision Making
- Collecting the right information for decision making.
- Consider emotions.
- Avoiding mental errors.
- Always consider a consistent approach.
- Keeping in mind the Long Term benefit.
Do Not be a Victim of Mental Accounting.
Emotion + Logic = Mental Accounting
You are going to watch a Movie for which you have bought a ticket for Rs. 100.
At the entrance, you have lost the ticket.
Will you buy another Ticket?
You are going to watch a Movie for which the ticket costs Rs. 100.
Now on your way to buy the ticket you have lost Rs. 100.
Will you buy the Ticket?
Most of the Time the answer for the First is NO and answer for the second is YES.
But what we do not realize is Rs. 100 = Rs. 100
When you are asked to spend from your Savings and Bonus. Your decision would be to spend on bonus because that is meant to be spent. Even though they are the same amount we avoid spending savings.
Which brings me the conclusion.
The way we spend money entirely depends on what is the source.
IMPORTANCE OF BEHAVIORAL FINANCE
Understanding behavioral finance will help the investor in taking the right decision. It also trains one’s mind to take a right decision considering all the information.
- Understanding Investor’s Goals
- Accepting the fact that Investors are Emotional.
- It is an essential aspect for Fund Managers and Financial Advisors.
- Helps in Investments and Trading Decision.
- Clears Biases in Trading and Investing.
The Propensity Effect Doesn’t Have To Be Hard. Read These
You Can Thank Us Later – Reasons To Stop Thinking About The Propensity Effect
These Will Help you To Improve At The Propensity Effect In 60 Minutes
Get Rid of Myth of Booking Profit and Holding on to your Losses.
Go Look at your Investing and Trading Strategy right away. These small tweaks will have a larger impact on your Trading and Investing activities.
With the right understanding on Mental Accounting, you would definitely become better at decision making.
Go and Tweak your Strategy Right Away.
Mention in Comments how The Propensity Effect benefited you.
Shefrin H. & Statman M. (1985) “The disposition to sell winners too early and ride losers too long: theory and evidence,” The Journal of Finance.