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
Behavioral biases are used as the primary predictor, and behavioral biases are anchoring bias, overconfidence, disposition, herding, risk aversion, and representativeness.
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 is behavioral biases of investors? ›
Behavioral biases hit us all as investors and can vary depending upon our investor personality type. These biases can be cognitive, illustrated by a tendency to think and act in a certain way or follow a rule of thumb. Biases can also be emotional: a tendency to take action based on feeling rather than fact.
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 10 behavioral biases? ›
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.
What are the five-five decision making biases and errors? ›
What are the common decision making biases? Common decision-making biases are overconfidence bias, anchoring bias, hindsight bias, confirmation bias, and availability bias.
What are the 5 unconscious biases? ›
Types and examples of unconscious bias
- Gender bias. Gender bias happens when a person has a stereotypical belief about someone based solely on their gender. ...
- Beauty bias. Beauty bias happens when employees form conclusions or opinions about others based on their appearance. ...
- Conformity bias. ...
- Affinity bias. ...
- Confirmation bias.
Examples of bias-based behaviors:
Disciplining a student more often or more harshly because of their membership in a protected group; Posting pictures of a student that make fun of them for being part of a protected group; Imitating someone with any kind of disability, or imitating someone's cultural norm or language.
What is the behavioral bias in which investors tend to avoid realizing losses? ›
Loss aversion is the tendency to avoid losses over achieving equivalent gains. Broadly speaking, people feel pain from losses much more acutely than they feel pleasure from the gains of the same size.
How to overcome behavioral finance biases? ›
Having a financial plan can help overcome financial behavior biases by providing a clear and structured approach for making financial decisions. Avoiding emotional decision-making: When emotions run high, biases are more likely to occur.
BLACKROCK'S APPROACH TO FACTOR INVESTING. BlackRock has identified five factors — value, quality, momentum, size, and minimum volatility — that have shown to be resilient across time, markets, asset classes, and have a strong economic rationale.
What are the four 4 behavioral factors? ›
The predominant four functions of behavior are attention, escape, access, and sensory needs. These four functions allow us to understand and categorize someone's actions, as well as determine why behaviors occur. All actions can be attributed to one of these four functions of behavior.
What is a good investor behavior? ›
Good financial behaviour involves making informed and strategic decisions with a focus on achieving long-term financial goals. To be a smart and rational investor, practice the below attitudes to your financial investments, while understanding your personal sensitivity to risk and your long-term goals.
What are the most common behavioral biases in finance? ›
Key Takeaways
Real traders and investors tend to suffer from overconfidence, regret, attention deficits, and trend chasing—each of which can lead to suboptimal decisions and eat away at returns. Here, we describe these four behavioral biases and provide some practical advice for how to avoid making these mistakes.
What are the 5 domains of bias? ›
Bias is assessed as a judgment (high, low, or unclear) for individual elements from five domains (selection, performance, attrition, reporting, and other). * If particular questions/entries were pre-specified in the study's protocol, responses should be provided for each question/entry.
What are the three behavioral biases? ›
To get us started, we have decided to focus on three; Endowment Bias, Loss Aversion Bias, and Anchoring Bias. (UPDATE: we've added three more: Overconfidence, Familiarity, and the Gambler's Fallacy).
What are the biases in impact investing? ›
The risk aversion bias significantly influences the investment decisions of investors. The representativeness bias significantly influences investors' investment decisions. The anchoring bias significantly influences the investment decisions of investors.
What are the 5 biases in research? ›
Above, we've identified the 5 main types of bias in research – sampling bias, nonresponse bias, response bias, question order bias, and information bias – that are most likely to find their way into your surveys and tamper with your research methodology and results.
What are the 5 steps in recognizing biases? ›
Review these tips to keep biases at bay during your decision-making process:
- Understand the effects of bias. ...
- Know what is influencing your decision. ...
- Question your biases. ...
- Use multiple sources. ...
- Reflect on your previous decisions.
