The psychology of retail investors in stock markets is a complicated subject that involves understanding the thoughts, emotions, and choices of individuals who participate in the stock market and other cognitive factors that influence their behavior and decisions. Here are some key aspects to consider:
1. Herd Mentality:
Retail investors often display a herd mentality, where they are likely to follow the actions and decisions of others like friends and colleagues, especially when they see a large number of people investing in a particular stock or asset. This behavior leads to a lack of individual creativity and drives investors towards decisions based on the actions of others rather than their analysis.
Example: Many fake experts or financial influencers create Whatsapp and Telegram groups; start giving tips for trading in intraday, futures, and options. There are some groups with lakhs of followers who blindly follow what their guru says. Ask yourself before trusting a person who boasts a profit of 5 or 10 lakhs per trade and earnings crores per month through trading. Why would he create groups and give tips to others if he is already earning crores? Compare this with any high-salaried individual who makes 25 or 30 lakhs per year; he wouldn’t have time to spend with the family. Here we see people claiming they earn crores per month, yet they find time to post twenty trades in the group every day.
2. Emotional Bias:
Emotions play a vital role in the decision-making process of retail investors. Greed and fear are two prominent emotions that drive our investment decisions. For example, fear can lead to panic selling during market downturns while greed can cause investors to chase hot stocks without thorough analysis.
Example of Fear: Many retail investors left markets in a hurry when Nifty fell to 7600 levels during the Covid-19 stock market crash. But, Nifty reached 18600 in the next 20 months in October 2021. It had been sideways for the next 20 months, and people started expecting another crash in 2023 and stayed away from the markets. Currently, it is at around new all-time highs of 19800 levels.
Example of Greed: Let us take the shares of Adani Transmission. From around ₹200 during Covid times, shares traded above ₹4000 by August 2022, a move of 2000% or 20 times. During the same time, net profit of the company was up by 81%. A rational investor would not have invested knowing that shares were trading at extreme premiums. Adani Transmission’s shares are trading at around ₹780 now, down by 80%. Imagine the pain of investors who bought the shares at its highs.
3. Overconfidence:
Many retailer investors exhibit overconfidence in their potential to pick stocks or timing the markets. This overconfidence often leads to excessive trading, taking on more risks than intended, and neglecting proper diversification. Overconfidence comes from a lack of experience, knowledge, and selective memory that focuses on successful investments while downplaying or forgetting failures.
4. Confirmation Bias:
Retail investors are inclined to seek information that confirms their existing beliefs or biases about a stock. They may ignore or overlook contradictory information that questions their views. This bias can hamper open-minded decision-making and prevent investors from considering alternative perspectives for investing.
5. Behavioral Biases:
Various cognitive biases influence the decision-making process of retail investors. Some common biases include Anchoring bias (relying too heavily on a single source of information like a particular financial guru, website, or media), Availability bias (giving too much importance to the readily available information), and Recency bias (giving significant importance to recent events or performance).
Example of all three behavioral biases: IT companies have been 20% to 50% from all-time highs since December 2021 (Recency bias). Most of the experts were bearish towards the IT sector because of flattening businesses, and financial websites were posting bleak outlook for IT companies. As a result, people who follow media or websites for information were skeptical of investing in IT stocks until a few weeks ago. (Anchoring and Availability biases). Nifty IT has been up 5.5% since last month.
6. Short-Term Focus:
Retail investors generally have a short-term perspective, seeking quick profits or reacting to immediate market trends. This thought process drives impulsive decision-making and neglecting long-term investment strategies. Such investors fail to identify the difference between investing and trading.
Scenario that covers all the above four biases (3 to 6):
After the Covid-19 stock market crash and lockdown situations, many new investors and traders entered stock markets. All they needed were a smartphone and some capital. Stock markets all over the world were zooming up. Nifty more than doubled in the next 15 to 16 months. Many Small and Mid-Cap stocks were up 20 times or more. So everyone seemed to make money in the stock markets. (Confirmation Bias and Recency Bias)
I remember some of my friends calling me asking why I was not able to make big money being full-time in investing. They were making almost 50% of their salary trading futures & options and intraday.(Overconfidence)
I warned them that markets fool anyone who thinks they are better than the markets and that making money in the stock markets is easy. As far as I was concerned, my returns were around Nifty’s since my investments were large caps and midcaps with good fundamentals.
The markets took a U-turn in October 2021. Most of the hot stocks were down more than 50 to 70%. Some of my friends lost their capital; they were frustrated because their hot stocks were falling and left the markets in distrust (Short-Term Focus). If they had invested at reasonable prices in good quality stocks with the potential for future business growth, it would have been comfortable for them to hold onto the investments in tough times.
7. Loss Aversion:
Retail investors are often more sensitive to losses than gains, it is known as loss aversion. They may hold onto losing positions for longer than necessary, hoping for a recovery rather than cutting their losses. Fear of regret or the desire to avoid admitting a mistake drives investors to hold onto losing trades. According to scientific research, the pain of losing money is thrice that of earning the same amount.
8. Lack of Financial Literacy:
Many retail investors may have limited knowledge and understanding of financial markets and investment principles. This knowledge gap contributes to irrational behavior, susceptibility to market rumors, and reliance on tips and recommendations from unreliable sources.
Learn about interest rates, inflation, types of assets to invest, stock market performance in the long term, differences between needs and wants, etc.
9. Lack of Diversification:
Many retail investors tend to concentrate their investments in a few stocks or sectors they are familiar with, neglecting the benefits of diversification. This lack of diversification exposes them to higher risk, as the performance of a single stock or sector can have a significant impact on their portfolio.
Example: Nifty 50 fell by 30% during Covid-19 Crash, while some large-cap stocks like Bajaj Finance fell by 55%. Small-caps stocks were down by 70% or more.
Conclusion:
Individual differences exist among investors, and not all retail investors exhibit these behaviors. The availability of online trading platforms and social media also influenced retail investors to a great extent in recent years. As investors, we should know the fundamentals of investing like reading financial statements, managing our finance, and not investing borrowed money and gambling in stock markets. We cannot make money in the stock markets by thinking and acting like everyone else.
Disclaimer:
I provide the information and my views on the website only to educate new investors and stock market enthusiasts on equity and other market investments. Please consult a SEBI registered financial advisor before making any investments in the stock or commodity markets. In case of any queries, you can contact me on Contact Form.
