Five behavioral biases that affect investors
Core points
Behavioral finance research aims to reveal irrational behavior and decision-making patterns in financial markets.
According to behavioral finance, investors can easily make suboptimal decisions because psychological effects complicate our decisions.
The five most common behavioral biases of investors: loss aversion, anchoring effects, crowd mentality, overconfidence, and confirmation bias.
Detailed explanation of the concept
Behavioral finance is a marginal discipline that intersects disciplines such as finance, psychology, behavioral science, and sociology, and aims to reveal irrational behavior and decision-making rules in financial markets.
It is based on factual premises such as investors aren't always rational, their self-control is limited, and the way they act is subject to their own biases.
To understand behavioral finance, we first need to understand traditional financial theory.
Traditional financial theory has three core assumptions:
Individuals have complete self-control.
Individuals have the channels and ability to understand all relevant data and information before making decisions.
Individual decisions are always consistent.
In short, traditional financial theory states that individuals always make the most rational decisions based only on available objective facts. Irrationality, however, is human nature. In fact:
We don't always have self-control.
We don't always have the time or channel to know all the data and information before making a decision.
We don't always agree when it comes to making decisions.
The difference between behavioral finance and traditional financial theory is that it emphasizes the role of psychology in individual behavior.
According to behavioral finance, investors can easily make suboptimal decisions because psychological effects complicate our decisions. By understanding our different psychological responses to emotions, we seek to limit the impact of emotions on our investment decisions.
Five behavioral biases that affect investors
Here, we list five common behavioral biases among investors, including loss aversion, anchoring effects, crowd mentality, overconfidence, and confirmation bias.
loss aversion
Investors are more concerned about losses than gains; this phenomenon is called loss aversion. As a result, some investors may want to get higher returns than losses to make up for their mentality. If they can't get high returns, they may tend to avoid any losses. Even from a rational point of view, certain investment risks are acceptable.
When an investment loses money, loss aversion makes many people choose to stick around rather than sell to bear the loss.
anchoring effect
The anchoring effect means that when making decisions, some investors place too much emphasis on previously obtained information (this is called an anchor), even if this information is unrelated to this decision. Investors with anchoring bias usually anchor the price of an investment to the original purchase price rather than fundamentals.
The mentality of following the crowd
The term crowd mentality refers to the phenomenon of people joining groups and following the actions of others. The instinct to be selfish is common in every aspect of society, including, of course, in financial markets. Investors prefer to follow other investors they see rather than rely on their own independent analysis to make judgments. Asset bubbles or market crashes caused by panic buying and panic selling are thought to be financial market phenomena caused by large-scale flock effects.
Overconfidence
Overconfidence bias means being too confident in our abilities and taking too many risks. This bias is common in behavioral finance and has a huge impact on capital markets.
Confirmation error
Confirmation bias is a term in cognitive psychology that describes how people naturally prefer information that confirms their existing beliefs. Behavioral finance experts have found that this basic principle applies particularly to market participants. Investors look for information that supports their current views, ignoring facts or figures that contradict them. As a result, their cognitive biases may reduce the value of their decisions.
