Most investors consider themselves rational in their decisions, but many of their behaviors contradict this notion. Research reveals that, despite knowledge and experience, most individuals are prone to psychological biases, which can obscure judgment and lead to making wrong decisions. Thus, understanding and, if possible, overcoming these biases is critical to long-term outcomes, decreasing risk, and enhancing performance.
In this article, we will go through some well-known cognitive biases that can have a measurable impact on financial decisions.
The inherent human inclination to seek or prioritize information supporting an existing conclusion or theory is known as confirmation bias. And because investors are deluged with evidence that appears to corroborate their judgments, it often results in overconfidence, one of the most common causes of trading losses.
In practice, confirmation bias can lead to investors overinvesting in a particular stock or sector; for example, a client who is heavily invested in a particular company may overlook negative news about it. As a result of putting too much emphasis on a single investment type, investors are more vulnerable to market downturns, thus affecting the overall balance of their portfolios.
To overcome confirmation bias, shifting away from impulsive decisions and toward a long-term portfolio with well-defined goals and strategies is necessary.
Loss aversion refers to investors' tendency to avoid losses over profits, leading to illogical and unwise investment decisions. It is one of the primary reasons why many investors underperform the market.
Loss aversion can cause investors to avoid taking risks, resulting in overly defensive portfolios. It may also encourage them to sell during a stock market slump solely to avoid more losses, resulting in them abandoning their long-term holding plan.
On the other hand, because of the intrinsic human tendency to avoid losses, investors who become entrenched owing to loss aversion are more likely to overlook new investment possibilities in favor of holding on to a losing investment in the hopes of recouping their losses.
Establishing systematic investment guidelines and rules can reduce this bias. Setting lower limits for positions held, for example, can be helpful. In addition, avoiding financial news can also aid investors, as it is frequently the trigger of this bias.
Information and Recency Bias
The tendency to evaluate information even when it is irrelevant to understanding a problem or issue is known as information bias. Indeed, it is highly challenging for investors to efficiently filter all information and focus solely on the pertinent ones.
According to various research, Daily market swings usually include no significant information for an investor with a medium to a long-term plan. However, the trend shows that short-term stock price changes frequently drive investors' decisions to buy or sell a position, which often leads to poor decisions that are entirely unconnected to the initial plan.
Similarly, when investors make judgments based on recent events, they face what is called recency bias. As they expect such events to continue in the future, it has the potential to cause them to make irrational decisions.
Therefore, to make more informed investment decisions, it is essential to carefully evaluate all relevant information before taking any action. Furthermore, instead of focusing exclusively on the day-to-day financial and macroeconomic climate, investors should take a broader view of how their positions move over time and the larger trends that may have a positive impact on their portfolios.
Hindsight and Anchoring
The tendency to see past positive market trends as predictable is known as hindsight bias. This is a harmful mindset because it makes it challenging to evaluate past investing decisions objectively and learn from past failures. Similarly, the anchoring bias is the propensity to hold on too tightly to a previous reference or information when making a decision. Many investors, for example, base their investment decisions on the current stock price in relation to its trading history, which is a clear anchor from a financial standpoint.
Nonetheless, numerous studies have demonstrated that basing investment strategies exclusively on historical performance can be highly misleading, as the market is influenced by various external, unpredictable factors.
In order to reduce these biases and make informed decisions, investors must properly evaluate each stock, understand the company's strategy and future operations, and forecast returns.
Trend Hunting, or Groupthink
Trend hunting, or groupthink, refers to a feeling of security in a decision made or held by a large number of people. The 2021 short squeeze event of GameStop illustrates this wonderfully. The actions and decisions arising from this mindset can be very risky – Speculative bubbles are usually the consequence of groupthink.
The ability to examine each investment decision independently should be the golden rule for all investors. While trends should be taken into account since they can depict new market orientations, emerging technologies, or general sentiment, they should only be utilized as a part of an investment decision, not as the only factor.
The restraint bias, or the tendency of investors to overestimate their ability to exercise restraint in the face of temptation, is another well-known bias. Scaling investments, selling excessively due to market assumptions, or overestimating investing fads are all examples of this behavior.
This bias can be overcome by optimal risk and limit management and tight compliance to the investment strategy.
The Bottom Line
In summary, behavioral finance is a phenomenon that has an impact on daily market movements. Numerous underlying biases have been identified that help explains major market anomalies, such as bubbles and recessions, more clearly.
Thus, understanding these biases can enable investors to make better, more rational investment decisions in a given financial climate, as well as anticipate market sentiment and act accordingly.