Risks associated with investing aren’t always external. Sometimes, we are misled by our own thoughts and emotions rather than the markets. Behavioral finance deliberates that combining the study of markets with psychological theory helps explain how investors’ decision-making processes impact overall outcomes.
- Biases can be cognitive, emotional or both
- Behavioral bias can lead to missed opportunities or increased risk
Today, behavioral finance has a larger part in the world of investing, bridging the gaps among evidence, theory and practice.
There is no straightforward way to simplify train of thought. Decisions are influenced by past experiences, fears, knowledge and emotions. While these factors can be useful in enabling the brain to take shortcuts for faster decision making, reflexive behavior also equates to financial decisions that may lead to undesirable outcomes.
Greater awareness of how knee-jerk responses can affect investment decisions can help investors avoid the pitfalls of behavioral risks. The most common behavioral risks that impact investors include:
- Loss aversion bias: This occurs when investors experience the pain of a loss greater than the pleasure of a gain. It can mean that investors hold on to certain investments for too long and avoid investments that could add more value to their portfolio.
- Herd mentality: Common even outside investing, people tend to follow where the crowd is heading. That doesn’t mean the crowd is always going in the right direction. In investing, herd mentality can be born out of fear of making mistakes and may lead to missed opportunities.
- Hindsight bias: This is when an investor perceives a past investment outcome as though it could’ve been predictable. Once something has happened, we’re fooled to believe that we knew it was going to take place. This bias gives investors a false sense of security when tackling investments and may lead them to take excessive risks.
- Confirmation bias: This happens when people observe, overvalue and seek information that confirms the claims they already believe. Such a bias can be detrimental to investment decision making because it often ignores other evidence that discounts their claims, even when the evidence proves them wrong.
- Status quo bias: This bias is about keeping things the same. People tell themselves that things have been a certain way for years and would rather maintain that status quo. Often, such investors can often carry this behavior across many areas of their lives. The negative impact this bias has on investments is that it can deter investors from making vital and necessary changes. Regular investment updates can better position a portfolio for the future amid evolving markets.
Behavioral risks such as these can be either emotional, cognitive or a combination of both.
Emotional biases are based on feelings rather than facts. They can overpower rationality, particularly in times of stress. Loss aversion is one type of emotional bias. Other examples include:
- Self-control bias: the tendency to consume today at the expense of tomorrow, which can encourage a short-term rather than long-term investment strategy.
- Illusion of control bias: belief that people have some power or ability to control and/or influence investment outcomes, even when it is highly improbable.
- Overconfidence bias: an unjustifiable belief that someone’s own thoughts and abilities are paramount and always right. This can be a detrimental bias that leads investors to ignore the facts, minimize important details and conduct less research.
Cognitive biases reflect how people think and often result from fallacies in memory, information processing or poor reasoning. Hindsight bias is an example of a cognitive bias. Some others include:
- Recency bias: the recall and over-exaggeration of patterns from recent events. This bias was widespread during the bull market of 2003 to 2007, when investors inaccurately believed that the stock market would continue to gain indefinitely.
- Cognitive dissonance bias: efforts to soothe personal discomfort by ignoring the truth and rationalizing decisions.
- Availability bias: guessing the probability of an outcome based on how usual it is in their lives. This leads investors to believe to stick to what they know versus venture into a new path that may be more difficult to research or fully understand.
Behavioral biases can create challenges for investors by making them more vulnerable to risks.
Behavioral biases can create challenges for investors by making them more vulnerable to risks. These biases can lead investors to ignore information that could minimize losses or improve long-term returns. Behavioral biases often induce shortcuts in thinking that fail to take all the facts into account, even the facts prove that an investor’s original thinking and bias is incorrect. They can stir investors to make moves too soon or too late. In effect, behavioral bias can lead investors to make poor decisions.
Behavioral finance is another school of thought for portfolio theory that, when used correctly, can help investors make more objective and thoughtful decisions. Greater understanding of behavioral biases are useful for examining the bigger risk picture. Risks aren’t always what they seem, but a carefully-thought long-term investment strategy is a behavioral solution.