In 1979, two leading psychologists, Daniel Kahneman and Amos Tversky, introduced the concept of Prospect Theory, which revolutionised the field of behavioural economics. So much so that the paper "Prospect Theory: An Analysis of Decision under Risk" was awarded the Sveriges Riksbank Prize in Economic Sciences in 2002.

Prospect Theory posits that people are risk averse and tend to value and behave differently towards gains and losses. They process these gains and losses as a value function that is concave for gains and convex for losses. The concavity for gains corresponds to risk aversion while the latter contributes to risk seeking for losses. It assigns greater significance to losses than gains which results in the value function being steeper towards the same.

Losses have a much more psychological and emotional impact on an investor's mind. Let's take an example.

Given two options: 

1. 100% chance of winning ₹1000

2. 50% chance of winning ₹4000, 50% chance of losing ₹2000 

So which one would you choose? Anecdotal evidence (we surveyed 119 people, and 76% chose the first option) suggests most people will intuitively prefer the former even though the expected value of both options is the same, i.e., ₹1,000. Even if the second option yields more economic benefit, let's say, instead of winning ₹4,000, you win ₹5,000 (pushing the expected value to ₹1,500), people would likely stay loyal to the safe bet.

The reason behind such thinking revolves around the pain of losing; it's much more painful losing 1000 bucks than cherishing a couple of 500s you found by the wayside. It's the same as putting your savings in fixed deposits rather than investing in the markets despite a decent probability of receiving much higher returns from the latter.

The theory also explains the illogical financial behaviour asserted by people in real-life scenarios: people refusing to work overtime because they do not want to pay more taxes or not putting their money in banks to earn interest. Although people would financially benefit from the after-tax income, the theory states that the marginal utility gained from the additional income is not enough to overcome or compensate for the feeling of loss incurred by paying taxes.

What You See is What You Believe

Any average investor interested in the markets usually tries to learn about charts, indexes, and technical aspects and(/or) relies on news to make decisions. Serious investors follow a proper process of recording trades regularly and reflecting on them. However, the most important factor of investing, often ignored by many (even experienced traders), is the psychological aspect - it is essential to understand your mental behaviour and state while carrying out trades. As the saying goes, "What you see is what you believe." Most people focus on visible aspects, such as profit numbers and stock prices, often ignoring what is not visible - the health and sustainability of the company. 

News channels and journalists often report on companies with booming and substantial profits. However, they fail to acknowledge that not all businesses achieve the same level of profitability (sort of a survivorship bias). These stories naturally attract the interest of many investors. Motivated by the limited knowledge presented by the media, these investors eagerly enter the markets, believing they will make substantial profits. Unfortunately, this approach lacks rationality as it fails to consider a broader and more nuanced perspective.

Once an investment captures a bull's interest, the focus shifts to only positive factors while disregarding the potential downsides that may have a devastating impact. This behaviour is known as confirmation bias, where investors seek confirmation of their assumptions while disregarding opposing facts and opinions. The media takes full advantage of such practices to frame and present data only meant to catch investor attention, and that's how one falls into the trap of making profits, which most of the time (almost all, in fact) ends up the other way around. Now that our bull has made the instant decision to put money into that famous stock (thanks to the media), he is impatient to make profits, and it is a general observation that markets don't work as per one's will. Hence, the confirmation bias is not equivalent to reality. The market takes a slight bearish angle/correction that goes against the objective of our naive bull. He tells himself, "Oh, it's just a small correction which will end up in an upward trend (confirmation bias); this is a golden opportunity to double my position!"- a dangerous attitude and proceeds to invest more money.

Further, if the price drops more, he would still convince himself with the thought, "It's already 60% down; there is no way it is going any lower than this!" - a classic illustration of anchoring behaviour, a cognitive bias that can undermine our critical thinking. It leads to the tendency to rely on short-term and irrelevant information as a reference and hold on to it. The decline in investment value contradicts the initial belief, creating a cognitive dissonance. The investor attempts to cope, trying to convince himself that the losses are only temporary and wants to hold onto the purchase price that acts as the psychological anchor. When the price drops any lower, he buys even more with the perception of making up for the initial losses. However, such irrational behaviour increases the risk of generating losses, leading to a never-ending bottomless pit. 

Not Letting Go: The Disposition Effect

So far, we have noticed that our investor has not yet sold his investments and is holding on despite repercussions. It is foreseeable that the prices will rise to some extent at a point, and when this point comes, he immediately decides to sell after holding on to the losses for too long, as now he is already stressed out and is afraid to face any more downside due to the psychological risk ability being too low. If the price increases after selling, he will consider such an increase as a forgone gain and feel disappointed. The disposition effect, a market anomaly, elucidates the behaviour of closing out winning positions faster than losing ones. 

It is considered one of the most robust behavioural regularities in trading analysis. If an investor holds a stock that has substantially risen in value, he may think of the stock as overvalued. If he is risk-averse, he will likely book profits. However, if he were risk-seeking, he may be inclined to hold on to a stock that has considerably fallen in value. Therefore, some people may continue to hold their position despite significant losses.

Conclusion

It is evident that simply having knowledge and mastering fundamental and technical analysis is inadequate to guarantee long-term profitability when participating in the markets. Learning feeds off adaptability - we tend to stick with what has worked for us and avoid change. In the end, understanding psychological behaviour during investing is difficult; it's a roller coaster of emotions influenced by the complexities that shape the human spirit.

By Soniya Yadav