Behavior Bias in Stock Trading

At times, any investor’s biggest problem and worst enemy is none other than themselves.

People believe that good things will happen to them only and bad things will happen to others. They also believe that others are less likely to become rich and become famous. Make no mistake; we have a tendency to follow the similar behavior while investing in the stocks. This is called behavior bias in stock trading. As a rule of thumb, there are two different ways to analyze the company’s performance before we make our investment decision. The first one is called fundamental analysis where we need to analyze company’s last three to five years (or longer depending upon our strategy) performance in terms of profitability, cash flow, return on equity, revenue and other accounting numbers with ratio analysis. The second one is called technical analysis where investors analyze the general historical stock price behavior/ trend along with market index of and decide when to buy and sell a stock. However, most of the time, and in general, we do not care much about both technical and fundamental analysis and simply invest based on our intuition, emotions and hunch. We have a brain, and the chemicals in our brain often force us to make irrational decisions. This also affects our decisions on stock trading or portfolio. This is called behavior biases in the stock / security trading. Investor behavior is often deviate from logic and reasons. Emotional process, mental mistakes and individual personality traits complicate investment decision. Therefore, we need to understand that investment is just more than a analyzing the numbers and making decision to buy and sell of various stocks/ securities. A large part of investment involves individual behavior. Ignoring to grasp this concept can have detrimental influence on portfolio performance. This article attempts to look into some of the behavior biases in the stock trading. Even though there are numerous behavioral biases that we as an investors exhibits, but this article is focusing on those behavior bias which is more prevalent in Nepali stock market.

 

Another reason is the common rationale that it's unlikely that such a large group could be wrong. Even if you are convinced that a particular idea or a course of action is irrational or incorrect, we might still follow the herd, believing they know something that we don't.

 

 

Herd Behavior

Most of the time, we simply follow our colleagues, friends, family or large group and make our buy and sell decision. In investment; this behavior is known as herd behavior, which is the tendency for individuals to mimic the actions (rational or irrational) of a larger group. This is the most prevalent behavior shown by investors in the Nepali stock market.

There are a couple of reasons why herd behavior happens. The first is the social pressure of conformity. We probably know from experience that this can be a powerful force. This is because most people are very sociable and have a natural desire to be accepted by a group, rather than be branded as an outcast. The second reason is the common rationale that it's unlikely that such a large group could be wrong. After all, even if you are convinced that a particular idea or course or action is irrational or incorrect, we might still follow the herd, believing they know something that we don't. This is especially prevalent in situations in which an individual has very little experience. Let’s take an example, In recent last three weeks,

NESPE index is falling and everyone is trying to sell their shares without knowing the fundamental reason. One year back, everyone was trying to buy shares as the NEPSE index was rising to the all time high. No one tried to ask why NEPSE index was rising and may be this was simply the speculative bubble which can be burst any time and price may fall soon. (Bubble is the situation when investors drive stock prices unreasonably high; above their true value; when there is no fundamental reason to support the rising prices of the stocks).

While it's tempting to follow the newest investment trends, an investor is generally better off steering clear of the herd. Just because everyone is jumping on a certain investment "bandwagon" doesn't necessarily mean the strategy is correct. Therefore, the soundest advice is to always do our homework before following any trend.

 

Disposition effect

We have a greater propensity to sell a stock which price has gone up in the value since we purchased it. There may be chances that we may earn more if we wait some more time. This is known as selling a winner too soon. But at the same time, if the stock price is falling, we do not want to sell it immediately and minimize the losses; hoping that the price may rebound in the future. These two opposite behavior in terms of selling winner stock too soon and holding on loser stock for long is known as disposition effect. In disposition effect, we have a tendency to seek risk when faced with possible losses (holding on loser stock too long) and to avoid risk when a certain gain is possible (selling winner too soon). The disposition effect is harmful to investors because it can increase the capital gain tax that investors can pay and reduce the return even before taxes. Therefore, the best advice is “cut your losses (sell the loser stock quickly) and let your profits run (wait the winner stock to climb high)”. This enables investors to engage in disciplined investment that can generate higher returns.

 

 

It is often seen that investors and traders react disproportionately to new information about a given security. This will cause the security's price to change dramatically immediately following the event. As a result, investors’ in the stock market overreact to new information, creating a larger-than-appropriate effect on a security's price.

 

Overconfidence

Another very prominent behavior bias that we exhibit in the stock trading is overconfidence. We have a tendency to become confident when we start earning from investing in the stocks. Confidence is fine, but we need to ensure that our confidence should not become overconfidence. Overconfidence can be described as unfounded faith in one’s judgments and cognitive abilities. It occurs when people have a tendency to think that they are better than they truly are and/or have a tendency to assign too tight confidence intervals for uncertain events. In one of the survey conducted in Europe, groups of students, professors, professionals, and investors were asked one question i.e. Compared to the drivers you encounter on the road, are you above average, average, or below average? How would you answer this question? Nearly everyone answered that they are above average. Clearly, many of them are mistaken and are overconfident about their skill in driving. If overconfidence were not involved, approximately one-third of those reading this would answer above average, one-third would answer average, and one-third would answer below average. However, people are overconfident in their abilities. Most people feel that they are above average. This behavior is also clearly visible in the stock trading. Research have shown that male investors are generally found to be more likely to perceive themselves as knowledgeable or skillful than females As a result, while both men and women exhibit overconfidence, men are generally more overconfident. Furthermore, young investors are expected to be more overconfident, especially highly educated ones. This may be because with more experience, self-assessment becomes more realistic and overconfidence more subdued.

Overconfidence may lead us to underestimate the associated risks of stock investing which may cause heavy financial losses in the future. One of the great challenges of trading is the fact that confidence is necessary to produce meaningful return and yet overconfidence can ensure catastrophic return. It has been seen that people started to be over confidence of their stock picking skill if they earned handsome return from their trading. It may be just luck or one time affair.

We need to understand that by entering into stock trading activities we are trading against analyst who extensively used computer data, professional speculators institutional investors and others around the country with better data and more experience than us. The odds are overwhelmingly in their favor. We need to do our self assessment frequently. We will likely to build wealth over time in the stock market if we invest for mid to long term, do not persuaded by short term market fluctuation, mirror indexes and take advantage of dividends. Most importantly, resist the urge to believe that our information and intuition is better than others in the market. If we can do it, we can overcome the overconfidence bias.

 

Underreaction and Overreaction

Have you ever wondered about what factors affect a stock's price? Stock market functions on information and it’s the information that affects the stock prices. The information can be company’s fundamental factors, economy of the country, and market trend. When any information comes to the market, buyers and sellers of a stock analyze the information and decide to buy and sell depending upon how they view the information. Those who think that the information is good news, they try to buy the stock and vice versa. The only problem is sometimes, and most of the times, market seems to overreact or underreact the news. Let’s take an example. NEPSE index opened at 1813.68 points and went down to 1770.51 points during the second trading hour of the day on August 4, 2016 when Mr. Puspa Kamal Dahal became new prime minister of Nepal. Let’s take another example; stock market in the world negatively reacted when British people voted for exit from European Union. Immediately after the result was declared, the U.S. and British stock markets fell more than three percent and European markets were down more than six per cent. Trillions of dollars of value, in other words, have been erased within 24 hours of the result. But after few weeks, stock markets slowly recovered. This is a perfect example of overreaction of news by stock market.

It is often seen that investors and traders react disproportionately to new information about a given security. This will cause the security's price to change dramatically immediately following the event. As a result, investors’ in the stock market overreact to new information, creating a larger-than-appropriate effect on a security's price. If there is excessive buying, it will push the price unreasonably high. Similarly, if there is excessive selling, it will push down the price. However, we need to understand that short term changes in the stock price due to some news is not necessarily going to remain there for long period of time. In fact, it has been seen that stock market correct itself within a reasonable time. In another word, price surge is not a permanent trend - although the price change is usually sudden and sizable, the surge erodes over time. Therefore, we should not be persuaded for buying and or selling of any stocks just because some new news came. We need to be patience and wait for some time to decide