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"You have to be able to control yourself. You can't let emotions get in the way of your mind."

- Warren Buffet

Introduction

Markets are assumed to be characterised by rational individual behaviour, with investors balancing risks and returns. When investors are rational, they value each security for its fundamental value, i.e., the net present value of its future cash flows discounted using their risk characteristics. But in practice, it is difficult to sustain the case that people in general, and investors in particular, are fully rational. Many investors react to irrelevant information in forming their demand for securities. As Fisher Black put it, they trade on noise rather than on information. Investors follow the advice of financial gurus, fail to diversify, actively trade stocks ,and churn their portfolios, sell winning stocks, and hold on to losing stocks, follow stock price patterns, and other popular models. This paper tries to capture some of the subjective elements of investors' decision making and psychology in the face of risk. Understanding these psychological aspects of risk enhances the investor's tenacity in an ever-changing market scenario.

1. Anchoring: Over Relying on First Thoughts

The human brain gives more weight to the first information it receives. Initial impressions, ideas, estimates, or data "anchor" subsequent thoughts. Anchors take many guises. They can be as simple and seemingly innocuous as comment offered by your spouse or a statistic appearing in the morning newspaper. Anchors often prejudice our thinking in ways that prevent us from making good decisions. Anchors are often used by savvy negotiators as a bargaining tactic. For example, you visit a local art dealer and seen on display is a unique and compelling painting by an unknown young artist - a work that has no clear market value. You estimate its worth at approximately Rs. 12,000, when you begin talking about the painting with the dealer, he immediately suggests a price of Rs. 40,000. As an opening gambit, that price may be designed to anchor you, to shift your sense of the piece's worth upward, If you respond by attempting to bargain down from Rs. 40,000, the final cost may be unduly influenced by the dealer's initial proposal - the anchor.

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Prof. Gangineni Dhananjhay is Assistant Professor - Finance in the M.B.A. Department at Vivekananda School of P. G. Studies, Hyderabad.