How Does Psychology Affect Your Investment Decisions?

“Behave yourself!” You would have heard this a while back in school. Teachers and parents emphasize on good behaviour from a very young age in order to mould us to become good Samaritans. Somehow this higher authority disappears in our adult life though for some it stays as the voice in our heads. Can Behavioural changes influence wealth creation? Apparently they do, which is the topic of this post “Behavioural Finance”.

Psychology

Behavioural finance combines conventional finance and economics with human judgement and emotion. It’s a blend of finance and psychology, aiming to study the influence of one on the other.

Price Anchoring

This is one of the oldest concepts in the subject, anchoring one’s perception of value to a specific number or method. The anchoring effect can be due to a logical or illogical reason. This is observed in the Indian Real Estate Market. The price of real estate can anchor on:

1. Last selling price of a similar real estate.
2. Price of a flat in a new apartment in the same area. A builder can market a place well to create a “new” base price which acts as an anchor.

There seems to be no logic in the anchoring of real estate in India and therefore it’s the most speculated. The moment the anchoring shifts downwards, we could potentially have a great crash. The stock market is not insulated from the anchoring effect either.

Always try to logically evaluate an asset. Try not to anchor your price on someone else’s estimate.

Mental Accounting/Perception

Mental Accounting is nothing but the perception that we have towards different spends. A typical example is the tendency to bargain on vegetables but at the same time spending a bomb on Friday night dinner. Mentally we are programmed to haggle on certain things but spend generously on others. This mental accounting can unconsciously make you a poor saver. Cut down on the restaurant visits instead of being thrilled on a 25% discount on a Kg of Onion or some free coriander from the sabziwala. This is the classic “Penny wise Pound foolish approach!” Actually mapping out your spends with the help of an App like Money View gives a striking picture of how you spend and on what.

Self-Fulfilling Bias

We look for reasons to support our pre-conceived conclusions. Personally, I am biased towards investing in the stock market and shunning real estate investments. I unconsciously search for data to support my conclusion. This is unscientific, biased and of very little use. One needs to re-think their philosophies of investing, challenge their status quo and aim to genuinely improve their decision making process. Don’t let pre-conceived biases get in the way of knowledge. People who have created long term wealth have constantly questioned themselves and evolved to become who they are.

Peer Pressure/ Follow the Herd

This is typical animal behaviour. Follow what others do! A million people cannot be wrong. This is not always true. In fact the greatest of thinkers have thought polar opposite to what the crowd thinks. The world was apparently flat once; the solar eclipse was God’s way of punishment; human beings were created etc. All of these were challenged and conquered. Investment can be decoded too with knowledge.

So if someone comes along and says, “Invest in my Mutual Fund”, ask the question “Is the market overpriced now?” Get down to studying the portfolio; who are the fund managers; what are the hidden costs? Modify your thought process!

Conclusion

Your emotions are deeply connected with your spends and investments. It is imperative you question yourself constantly to attain greater success in investment. Spend more on that olive oil by all means but don’t forget to invest in exercise too.

Arjun Balakrishnan is an investment fanatic who loves writing about investment topics. He regularly writes at Investment Gyaan.