Key Takeaways
Behavioralfinanceisthestudyofpsychologicalimpactsoninvestors’behaviors
Differentfromtraditionalfinancetheory,behavioralfinanceemphasizestheroleplayedbypsychologyinindividualbehaviors
The fivemostcommonbehavioralbiasesare lossaversion,anchoringbias,herdinstinct,overconfidencebias,andconfirmationbias
Understanding behavioral finance
Behavioral finance studies the psychological impacts on the behaviors of investors and the subsequent effects on the markets. It is based on some facts, such as investors are not always rational, their self-control is limited, and how they behave is subject to their own biases.
To understand behavioral finance, we first need to understand traditional finance theory. Traditional finance theory is comprised of three core assumptions:
Individuals have complete self-control.
Individuals understand all available data before making decisions.
Individuals are always consistent in their decision-making.
In a nutshell, traditional finance theory states that individuals always make rational decisions solely based on objective facts available.
However, irrationality is built into human nature. In reality:
We don't always have self-control.
We don't always have time to understand all the data before making a decision.
We are not always consistent in terms of decision-making.
Behavioral finance is different from traditional finance theory in that it emphasizes the role played by psychology in individual behaviors.
Accordingtobehavioralfinance,investorsarevulnerabletomakingsub-optimaldecisionsduetopsychologicalinfluencesthatcomplicateourdecision-making.
By understanding the different psychological responses to our emotions, we attempt to limit the effect of emotion on our investing decision-making.
Five Behavioral Biases Affecting Investors
Here, we highlight five prominent behavioral biases common among investors. In particular, we look at loss aversion, anchoring bias, herd instinct, overconfidence bias, and confirmation bias.
Loss aversion occurs when investors care more about losses than gains.
As a result, some investors might want a higher payout to compensate for losses. If the high payout isn't likely, they might try to avoid losses altogether even if the investment's risk is acceptable from a rational investor's standpoint.
In investing, loss aversion can lead to the so-called disposition effect when investors sell their winners and hang onto their losers. Investors do this because they want quick gains. But when an investment is losing money, many of them would choose to hold onto it because they want to get back to their initial price.
It means some investors tend to be over-reliant on an arbitrary benchmark such as a purchase price or sticker price. Market participants with an anchoring bias tend to hold investments that have lost value because they have anchored their fair value estimate to the original purchasing price rather than to fundamentals.
The term herd instinct refers to a phenomenon where people join groups and follow the actions of others because they assume that other individuals have already done their research.
Herd instincts are common in all aspects of society, including the financial sector, where investors follow what they see other investors are doing rather than relying on their own analysis. Asset bubbles or market crashes by panic buying and panic selling are believed to manifest herd instinct at scale.
Overconfidence bias means being too confident in our abilities, making us take excessive risks. This bias is common in behavioral finance and can exert huge impact on capital markets.
Overconfidence has two components: being confident in the quality of your information and in your ability to act on said information at the right time for maximum gain.
Confirmation bias is a term in cognitive psychology that describes how people naturally favor information that confirms their existing beliefs.
Experts in behavioral finance have found that this fundamental principle applies notably to market participants. Investors search for information that confirms their existing opinions and ignore facts or data that contradict them. As a result, their own cognitive biases may reduce the value of their decisions.
FAQs
Five Behavioral Biases Affecting Investors
What are the biases of investors behavior? ›
Emotional biases include loss aversion, overconfidence, self-control, status quo, endowment, and regret aversion. Understanding and detecting biases is the first step in overcoming the effect of biases on financial decisions.
What are the behavioral factors of investors? ›
Some common behavioral financial aspects include loss aversion, consensus bias, and familiarity tendencies. The efficient market theory which states all equities are priced fairly based on all available public information is often debunked for not incorporating irrational emotional behavior.
What are the behavioral biases investors can generate? ›
This behavioral bias can increase the risk of the portfolio while limiting expected returns. Similarly, the framing bias is a cognitive error that results from making buy/sell decisions based on whether an investment is perceived to be held at a gain or a loss.
What are the biases in impact investing? ›
A common behavioral bias in investing is overconfidence, which causes investors to overestimate their judgement or the quality of their information. This can lead to “doubling down” on a losing investment instead of knowing when to cut losses, or under-reacting to important information about changing market conditions.
What are the five 5 biases which people have when investing? ›
Five Behavioral Biases Affecting Investors
Here, we highlight five prominent behavioral biases common among investors. In particular, we look at loss aversion, anchoring bias, herd instinct, overconfidence bias, and confirmation bias. Loss aversion occurs when investors care more about losses than gains.
What are the 4 behavioral biases? ›
However, this same trait does not apply well to asset allocation. In behavioral finance, there are four biases that distort people's perception of investments' value, undermining financial success: endowment bias, affinity bias, mental accounting bias, and anchoring bias.
What are some Behavioural factors? ›
Behaviour is affected by factors relating to the person, including:
- physical factors - age, health, illness, pain, influence of a substance or medication.
- personal and emotional factors - personality, beliefs, expectations, emotions, mental health.
- life experiences - family, culture, friends, life events.
Factors to consider when investing in a company
- The company's management team. Simply put, a management team should make sense for the business. ...
- The company's financial situation. ...
- The company's competitors. ...
- The company's customers. ...
- The company's suppliers. ...
- The company's industry.
Second, we list the top 10 behavioral biases in project management: (1) strategic misrepresentation, (2) optimism bias, (3) uniqueness bias, (4) the planning fallacy, (5) overconfidence bias, (6) hindsight bias, (7) availability bias, (8) the base rate fallacy, (9) anchoring, and (10) escalation of commitment.
Behavioural biases are caused by various factors such as simplification of the decision process, reliance on past values, status quo bias, personal identification with the decision, and social factors .
How do you overcome behavioral bias in investing? ›
By understanding what your biases are, you can learn how to avoid them when making investment decisions. By follow a robust long-term strategy is more likely instead of your unconscious whims, you're more likely to achieve your financial goals.
How biases affect investor behaviour? ›
Common human biases that investors should understand when it comes to investing is extremely important. These biases are ingrained in human nature, leading to tendencies to oversimplify, rely on quick thinking or exhibit excessive confidence in judgments, which may lead to investment mistakes.
What is an example of investor bias? ›
Example of Bias
Bias can be seen in the way people invest. For example, endowment bias can lead investors to overestimate the value of an investment simply because they bought it. If the investment loses money, they insist they're right and the market will surely correct its error.
What are behavioral biases of mutual fund investors? ›
Bandwagon Bias/Herd Mentality
Similarly, if you invest in schemes because other investors are doing it, this bias may not be ideal for you. Each investor, their investing journeys, risk appetites and goals are different, and thus, a fund that suits one portfolio may not suit another.
What is the present bias in investing? ›
Present bias occurs when people place far more weight on near-term benefits at the expense of longer-term ones. This can negatively impact investing decisions by favoring short-term gains over long-term growth. Investors may experience present bias as hyperbolic discounting.
What is the behavioral bias in which investors tend to avoid realizing losses? ›
Understanding Loss Aversion
The fear of realizing a loss can cripple an investor, prompting them to hold onto a losing investment long after it should have been sold or to offload winning stocks too soon—a cognitive bias known as the disposition effect.
What are cognitive biases in investing? ›
A cognitive bias is a systematic flaw in reasoning that can lead to making wrong decisions while investing. A common maxim in investing is that 'you are your own worst enemy. ' Humans are naturally hard-wired to look for shortcuts and avoid complexities, but taking the easy road in investing can be very dangerous.
What are the emotional biases of investments? ›
Emotional biases occur spontaneously and naturally when an important decision is being made. These biases are usually ingrained in the physiology of investors due to an individual's personal experiences and can be harder to overcome than cognitive bias.
