Investing is an intricate business where financial decisions often go beyond mere numerical calculations. Standard finance theory operates on the premise that people make rational decisions based on the information provided to them. This logic is countered by behavioral finance which focuses on the psychological and emotional aspects of investing. Merging psychology with financial theory aims to clarify some of the most inexplicable phenomena in finance where people, even with full knowledge of better options, choose to make poor financial decisions.
In this article, we look into what behavioral finance is, its most relevant biases, and the way it affects your investment decisions.
What Is Behavioral Finance?
Making financial decisions is often impacted by feelings, pre-existing biases, and social interactions, all of which fall under the domain of behavioral finance. This is a branch of study that uses psychology to understand why investors tend to irrationally deviate from prescribed financial plans and undertake actions that go against their best interests.
Instead of rational decisions being made by the market, traditional finance assumes that the market operates efficiently. Behavorial finance, on the other hand, argues that due to emotions, mental shortcuts, and biases, choices heavily influenced can still be market governed. Because of these factors, inefficient markets, asset mispricing, and indecisive decision making comes into place.
Important Psychological Behavior Biases in Behavioral Finance
- Loss Aversion
Behavioral finance clams that people feel the pain of losing something than gaining a new one. It’s called loss aversion. In a psychological frame, losses tend to be more powerful than equivalent gains. l This bias results in investors never pulling the trigger when they need to, as the negative impact on emotion derailing a loss outweighs any possible positive impact on a feasible gain.
One example is losing a stock: the petrified effect of realizing a loss outweighs every forecasted outcome which might make recovering on that investment easier in the future. Their behavior may result in a scenario where they can’t stop incurring losses and reallocating their investments become impossible.
Impact on Investments: Loss aversion may hinder decision-making by causing spilling investments to be sold too early and holding on to losers for too long. Investors may also become overly cautious and miss out on very good opportunities simply because they are too scared of getting losses.
- Overconfidence Bias
Investors either underestimate or overestimate the accuracy of their predictions. In this case, overconfidence bias takes place. This leads to assuming that their set of knowledge or skills is much higher than that of their counterparts creating a justification to take unnecessary risks. Overconfidence bias is manifested through excessive frequent trading and underestimating risks involved. For example, overconfident investors have a general assumption that they can time the market or make better than average returns by hand-picking stocks.
Impact on Investments: Those with overconfidence bias tend to impulsively and drastically change their portfolios, risking a great amount of loss in a gambled trade. Over-trading leads to lessening the investors’ profits due to increased transaction costs, or taking higher risks by decreasing risk-diversification assure profits.
- Herd Behavior
Herd behavior describes the tendency of people to follow what other people are doing, even when there is no rational or sound information to support it. In herd behavior, investing can create bubbles that drive up asset prices due to collective behavior, or panic selling during a downturn.
A quintessential example of herd behavior would be the dot-com bubble of the late 1990s, or the housing bubble that led up to the financial crisis of 2008. Investors sailed to these assets simply because other people were ignoring these assets’ underlying fundamentals.
Impact on Investments: When the crowd follows the leader, automatic decisions such as buying overvalued assets in a market rally or panic selling and selling a perfectly good investment can be made. Following the herd can mean that, in their self-imposed financial blindness, make decisions that don’t serve their financial interests best.
- Anchoring
Anchoring is a cognitive error in which people focus too much on the initial piece of information (the “anchor”) received when making a decision, no matter how irrelevant that information might be. In terms of investing, an anchor might be an investor’s first purchase price of a stock. For instance, if a stock’s price has fallen significantly from an investor’s original purchase price, he/ she may be anchored to the original price and stubbornly refuse to sell because hope persists that one day the stock may regain that worth.
Impact on Investments:
Problems arise when investors fail to re-evaluate their investment portfolio based on current market data due to excessive reliance on outdated information. As a consequence, investors may choose to cling onto a stock or an asset purely based on emotional attachment, disregarding whether it is economically sensible or prudent given current market conditions.
- Confirmation Bias
Confirmation bias describes a situation in which a person will look for information that supports their prior beliefs while ignoring the information that goes against it. For example, a bullish investor will focus only on the company’s news which is positive while disregarding the negative press and other relevant unfavorable information about the company. This further entrenches their belief and the investor is unable to make objective decisions about his investments.
Investments Effects: Conformation bias can impair an investor’s decision making as an investor may ignore important details due to an already established investment plan. An investors lack of diversification can be due to focusing on only a specific aspect of a view or ideology.
Effects of Behavioral Finance on Investments
Having knowledge about behavioral finance allows you to prepare for the blunders that may come your way if you have no plan in regard to your investment strategy. These factors are bound to affect your finances:
- Market Volatility Emotions such as fear or greed can influence a person’s decision. This is why behavioral finance is an important field, not only does human fundamental play a role but the being can also cause market volatility. Investors can react strongly to certain news which in turn can cause for periods of intense price increases or decreases.
- Decision Making Under Uncertainty: Investors are targeted by the uncertainty or unpredictability of the market. With that comes loss aversion, overconfidence, and various other biases. These can result in actions that are not suitable for one’s long-term goals.3. Risk Adaptability: The application of behavioral finance theory indicates that your risk adaptability may not hold constant over the time period. You may become more cautious during market downturns, while during bull markets, you could overextend yourself. Learning about these characteristics assists in developing a suitable long-term investment plan.
- Successful Investing Over Time: Due to behavioral biases, investors are most likely to drift away from their long-term investing strategies. Being aware of the most common biases and following self-correcting strategies such as maintaining a balanced portfolio, focusing on the bigger picture, and not loss-chasing can increase one’s chance of successful investment.
Countering Behavioral Biases
While it will be difficult to detach completely from the emotional aspects of investing, these methods can help counter the effects:
- Stick to a Plan: Formulating and following a proactive investment plan that is aligned with your objectives and risk veracity should shield investors from the temptation of capricious choices. Following up with your set agenda can improve outcomes.
- Diversification: Being invested in different classes of assets aids in reducing portfolio volatility as well as protects the portfolio from emotional decision-making. It buffers the portfolio from random fluctuations due to mass mentality or market movements.
- Rebalance Regularly: Managing your portfolio helps you to avoid getting distracted by fleeting trends as it works toward your long-term objectives. Flexible portfolios tend to perform better over the long term.
- Educate Yourself: Gaining familiarity with biases and their psychological factors can help you identify your emotional judgment lapses.
Conclusion
Behavioral finance provides insight into the psychological influences that encourage us to make mesmerizingly poor financial decisions. Understanding biases such as loss aversion, overconfidence, and herd behavior allows greater self-awareness related to decision making. It is quite unlikely to totally disregard emotions while investing but the acknowledgment of biases and some counterstrategies can drastically improve one’s investments over time.