According to conventional financial theory, the world and its participants are rational human being and strive to maximize their wealth prudently. However, there are many instances where emotion and psychology influence our decisions, causing us to behave in unpredictable or irrational ways. Dean of Wall Street, Mr. Benjamin Graham stated in his popular book “The Intelligent Investor” that markets are more psychological and less logical. Behavioral finance, a relatively new field of finance, attempts to combine behavioral and psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.
Here are some of the main behavioral biases that investors need to look out for:
Loss-aversion bias: Loss aversion refers to investor's tendency to strongly prefer avoiding losses to acquiring gains. The fear of loss leads to inaction. Studies show that the pain of loss is twice as strong as the pleasure of gain of a similar magnitude. Investors prefer to do nothing despite information and analysis favouring a particular action that in the mind of the investor may lead to a loss. Holding on to losing stocks, avoiding riskier asset classes like equity when there is a lot of information and discussion going around on market volatility are manifestations of this bias. In such situations, investors tend to frequently evaluate their portfolio’s performance, and any short-term loss seen in the portfolio makes inaction their preferred strategy.
Confirmation bias: Confirmation bias, also called my side bias, is the tendency to search for, interpret, or prioritize information in a way that confirms one's beliefs or hypotheses. It is a type of cognitive bias and a systematic error of inductive reasoning. For example, when a trader buys a stock for a reason and that reason doesn’t work out, so the trader makes up another one for owning the position. Similarly, first we make decision in mind and then find for the information to justify that intuitive decision.
Ownership bias: Things owned by us appear most valuable to us. Sometimes known as the endowment effect, it reflects the tendency to place a higher value on a position than others would. It can cause investors to hold positions they would themselves not buy at the current level.
Gambler’s fallacy: Predicting absolutely random events on the basis of what happened in the past or making trends when there exists none. It is the mistaken belief that if something happens more frequently than normal during some period, then it will happen less frequently in the future, or that if something happens less frequently than normal during some period, then it will happen more frequently in the future (presumably as a means of balancing nature).
Winner’s curse: Tendency to make sure that a competitive bid is won even after overpaying for the asset. While behaviorally it is a win, financially, it may be a loss.
Herd mentality: This is a common behaviour disorder in investing community. This bias is an outcome of uncertainty and a belief that others may have better information, which leads investors to follow the investment choices that others make. Such choices may seem right and even be justified by short-term performance, but often lead to bubbles and crashes. Small investors keep watching other participants for confirmation and then end up entering when the markets are over heated and poised for correction. Most of the individuals don’t go against the crowd as economist John Maynard Keynes said: “It is better for reputations to fail conventionally than to succeed unconventionally.”
Anchoring: Anchoring is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered when making decisions. Investors hold on to some information that may no longer be relevant, and make their decisions based on that. New information is labelled as incorrect or irrelevant and ignored in the decision-making process. Investors who wait for the ‘right price’ to sell even when new information indicate that the expected price is no longer appropriate, are exhibiting this bias. For example, they may be holding on to losing stocks in expectation of the price regaining levels that are no longer viable given current information, and this impacts the overall portfolio returns. Actually, the decision should be made purely on the basis of what price and value difference exist today in light of available information rather than based on what the prices were in the past.
Projection bias: We project recent past to the distance future completely ignoring the distant past.
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