We think about it in terms of markets not being efficient – everyone acts rationally, considering all available information at the time they make investment decisions. However, the realm of behavioral finance demonstrates that investors are not always rational; they suffer from cognitive biases that can lead to less-than-ideal financial decisions. By recognizing and adapting to these biases, investors stand a greater chance of making better decisions – which could add up to improved investment results.
What is Behavioral Finance?
Behavioral Finance: is an amalgamation of psychology and economics that uses intellectual theory to better explain why people make irrational financial decisions. It explains how psychological biases affect investors and financial professionals/practitioners.
Contrary to traditional financial theories (which assumed that in transparent, efficient markets the prices would reflect all available information), behavioral finance demonstrates this theory is not true; making informed decisions still proves difficult.
Common Cognitive Biases in Investing
Here are some of the most common cognitive biases that can affect investment decisions.
Confirmation Bias – This bias is self-explanatory; investors tend to be overly selective with the information they receive (seeking others opinions that align with theirs) while completely ignoring conflicting evidence. One example is an investor who thinks positively about a particular stock may only collect positive news on the company and ignore potential red flags.
Loss Aversion: People suffer more from the pain of losses than they enjoy an equivalent gain on their winnings. Investors who experience anxiety or are not prepared emotionally to absorb losses can be so risk-averse that they hold onto losing investments in the hope of breaking even, and sell winners too soon.
Overconfidence – Investors believe they can time the market or pick winning stocks. As a result, participants may engage in too much trading and under-diversify their portfolios or require more risk than necessary.
Herd Mentality (Follow the Leader): Investors can also create positive feedback by buying assets that are popular and forgoing those being shunned to band together with others who think similarly.
Anchoring: This bias is the act of anchoring around what you know, which in turn limits the flow of information when making decisions. An investor using it might focus on a stock’s previous high price as a benchmark, without reference to relevant fundamentals that could significantly reduce its current valuation.
Recency Bias – An investor tends to remember recent events and make financial decisions based only on that so we should not extrapolate short-term trends too much into the future. This may lead investors to a hot hand bias, blindly putting money into asset classes or strategies that have already performed well in the past without evaluating them from a long-term point of view
Availability bias: We all make decisions with information that is most easily retrievable or top-of-mind rather than incorporating the context of additional facts. An example of this could be investors who believe ascribe a much higher probability to the coming crash, having read an article about uncertainty.
Overcoming Cognitive Biases
You can never remove cognitive biases 100%, but being aware at least helps to decrease it physical effects. We outline ten strategies investors can use here…
Systematic Investing – Apply a clear investment process constructed on specific criteria This reduces emotional and bias factors in decision-making.
Discover New Ways of Thinking: Ask yourself if the information affirms your beliefs or challenges them Maybe start tithing, or spend time with investors who see things differently.
Decision Journal: Write down your investment decisions and what you thought when making them. This can assist you in spotting common threads with your logic, and possible biases that dictate how we go about picking traders.
Jacobi Checklists: Develop and use checklists for investment decisions to force you beyond ease thinking (the things that come easiest) icon_arrow
Mindfulness: How do you feel when investing? But if you are especially afraid or greedy now, it is better to postpone major decisions.
Stay Diversified: Individual security or sector biases can be offset by a well-diversified portfolio.
Set Rules and Stick to Them: Define rules for yourself around when you will buy, sell, and rebalance your portfolio. This will allow you to avoid impulsive decisions based on short-term market actions.
Skill #5: The Ability To Educate Yourself On Behavioral Finance & Cognitive Biases The more you know about any of these principles, the easier it is going to be for YOU to notice them and address each of the things that I say are mistaken in your rewrite practice.
The Role of Technology
Another way advances in technology are helping investors avoid their cognitive biases For example, robo-advisors apply algorithms to investment decisions to limit the extent of emotion and bias on human psychology. But it is also worth noting that these technologies are not perfect and can be prone to their own biases, often depending on how they were programmed.
Conclusion
The psychological aspects of investing are one area that behavioral finance sheds light on. Understanding common cognitive biases and developing strategies to combat them can help investors move toward more rational, disciplined thinking.
Now, the objective is not to take emotions out of investing altogether — that would be an exercise in futility and might work against you. But the goal is to be able to notice when you may have cognitive bias and then know how to trick yourself out of it.
In the end; being self-aware and open-minded is important. Having a better understanding of your own biases and decision-making could potentially lead to enhancing long-term financial outcomes as you venture out into the world of investing.