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Psychological Factors affecting stock market investing


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It's been often said that we are our own worst enemies, for the mindless decisions we make, as well as our frequent inability to learn from them. Nowhere is this more evident than in the stock markets, where this enemy from within us has a way of making us too confident, too timid, too impulsive, and too staid - sometimes even all at once.
View the presentation to know more about these traps and how to avoid them.

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Psychological Factors affecting stock market investing

  1. 1. Psychological traps affecting stock market investing
  2. 2. Introduction“We are our own worst enemies, for the mindless decisions we make, as well asour frequent inability to learn from them.”Nowhere is this more evident than in the stock markets, where this enemy fromwithin us has a way of making us too confident, too timid, too impulsive, andtoo staid - sometimes even all at once. Bullish Market Investor is hopeful Bearish Market Investor is fearful
  3. 3. Major Emotions driving InvestorsFEAR HOPE
  4. 4. Psychological Traps Heuristic - Driven Biases• Heuristic learning process is one in which people develop investment decision making rules through experiment, trial and error or personal experience.• Rather than research investment ; individuals form investment rules and make investments using information that is most prominent in the media or otherwise most readily available
  5. 5. Heuristic driven Biases Representatives OverconfidenceAnchoring and AdjustmentAversion to ambiguity
  6. 6. Heuristic - Driven BiasesRepresentatives• In this type of bias, investors base expectations upon past experience by applying stereotypesExample:• An investor might feel that all firms with management espousing environmental awareness are good firmsDrawback• In this type of bias the investor applies" if then heuristic" that is if this happens than the other thing will happen.• As it is just based on thumb rule; it can give bad investment results
  7. 7. Heuristic - Driven BiasesOverconfidence• Overconfidence is when individuals are too confident in their ability to predictDrawback• Overconfidence can lead to increased trading and less portfolio diversification• It can also lead to surprises since the investor continuously underestimates the range of possible returns
  8. 8. Heuristic - Driven BiasesAnchoring and Adjustment• It refers to the inability to fully incorporate the impact of new information on projectionsExample• An analyst may have already made a forecast for the performance of a stock, when the firm releases new information that can have a material effect on the stock price• The analyst being anchored by his prior projection will tend to not fully reflect the full value of the new information in his revised projections
  9. 9. Psychological TrapsFrame dependence• Frame dependence implies that individuals make decisions and take actions according to the framework within which information is received or the individuals circumstances at that time
  10. 10. Psychological Traps Loss aversion• It refers to the individuals reluctance to accept losses• A stock may be down considerably from its purchase price, but investor holds on to it, hoping that it will recover• You can relate this to a gambler who keeps throwing the dice, hoping to break even
  11. 11. Psychological TrapsSelf control• Self control that is controlling ones emotions is related to frame dependenceExample• Consider a stage of life and dividends• A younger, affluent investor may totally avoid high dividend paying stock because of the related tax consequences and the effect on portfolio return thus this can create bias in the long term
  12. 12. Psychological TrapsRegret minimization• Regret is the feeling associated with making a bad decision. The investor starts thinking, "if only I had.."Example• After selling winning stock ,and then watching it soar even higher, the investor starts thinking, "if only I had held on a little longer"• Alternatively, the same investor after holding onto the stock and watching it fall back, might say," if only I had sold the stock last week"Drawbacks• To avoid the possibilities of regret ;investors tend to stay in comfortable investments like bonds and defensive stocks and hold on to looser investments for too long
  13. 13. Psychological TrapsMoney illusion• Money illusion refers to the way individuals react to inflation and its impact on investment returns• People mostly think in nominal terms without any regard to inflation and its effects this can lead to a wrong mean variance analysis
  14. 14. Conclusion• Psychological traps can lead to biases while making investment decisions• So the investors must base their investment and trading decisions on rational mean variance analysis and risk return profile rather on rules based on experience and trial and error because it can lead to losses in the long term
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