Question

1. An investor owns 1,000 shares of IMAX Corporation. This individual thinks the company has a huge growing potential and decides not to sell any of the holdings. Explain the underlying behavior finance concepts involved and how they drive the investment decision making.

Answer 1

The concept of Behavioural biases interferes with rational investor assumptions and drive investment decisions governed by emotions, overconfidence, regret and so on. An investor who owns 1000 shares of IMAX corporation believing the company has huge growth potential and decides not to sell any of the holdings must be going through several behavioural biases leading to the concentrated portfolio and high risk. Some of the behavioural biases are noted as under:

1. Confirmation bias: The investor incorporates all the positive information which affirms his belief but ignores all the negative information.  An investor whose thinking is subject to confirmation bias would be more likely to look for information that supports his or her original idea about an investment rather than seeks out information that contradicts it. This makes him believe in the potential of the company and not sell the stocks in light of new information.

2. Regret aversion bias: He has a fear that if he sells the stocks and they rise in value, he will not be able to participate in the profits. Hence, making him keep the holding of shares intact.

3. Disposition effect: If he has made a loss on that stock recently, he will hold it for a longer period so as to be able to recover his losses. Disposition effect refers to the behaviour wherein the investor has a tendency to sell winners quickly and keep losers for a long time.

4. Familiarity Bias: If an investor is familiar with the operations or management of the company, they have a tendency to believe that the company is definitely going to do well as it is in safe hands.

5. Trend chasing bias: If an investor has seen a profitable trend in past, they tend to believe that past trends will carry into the future as well.

Hence, behavioural biases such as above drive investment decision making based more on emotions than rational thinking.