- Traditional Financial Theory
- What is Behavioral Finance Theory?
- What are the two pillars of behavioral finance?
- What is cognitive bias?
- What is emotional bias?
- Overcoming Behavioral Finance Issues
- How to overcome your biases.
Traditional Financial TheoryIn order to better understand behavioral finance, let’s first look at traditional financial theory.Traditional finance believes that both the market and investors are perfectly rational beings, have perfect self-control, and decisions about stock-picking are taken after cold-calculations of all statistics. It also believes that investors truly care about utilitarian characteristics. They are not confused by cognitive errors or information-processing errors.
What is Behavioral Finance Theory?Behavioral finance focuses on the cognitive and emotional aspects of humans. Behavioral theory says that Individuals are not rational and more often than not take irrational decisions despite having all the information, statistics, and research in hand which could significantly alternate their returns on investment. It says that investors have limits to their self-control and are influenced by their own biases. Cognitive biases like overconfidence, herd mentality, and loss aversion mainly occur from statistical, information processing, or memory errors, while emotional bias stems from impulse or intuition. This results in action based on feelings instead of facts.
What are the Two Pillars of Behavioral Finance?The two pillars of behavioural finance are cognitive psychology and emotional biases. Cognitive psychology explains how people’s subjective thinking affects their rationality in making judgments. While some biases are cognitive in nature such as confirmation bias, anchoring bias etc., others are emotional biases such as loss aversion bias, overconfidence bias etc. Emotional biases tend to result from intuition and reasonings are often influenced by feelings.
What is Cognitive Bias?Cognitive bias is basically error in processing statistics, information or memory. Cognitive errors typically result from wrongful reasoning. They are easier to rectify as they arise due to error in judgment rather than an emotional predisposition. They can be further classified into 2 parts:
- Belief Perseverance Biases - Belief perseverance bias in an individual force them to follow their beliefs. The belief is maintained by committing statistical, information-processing, or memory errors. They are a type of psychological bias of cognitive dissonance. It include conservatism, confirmation, representativeness, illusion of control, and hindsight.
- Information-Processing Biases - Information-processing biases result in processing information illogically or irrationally. Information-processing biases include anchoring and adjustment, mental accounting, framing, and availability.
What is Emotional Bias?Emotional biases result due to the inability to control one’s own emotions when making a financial decision and letting your emotions take over rational decision-making process. This includes loss aversion, overconfidence, self-control, status quo, endowment, and regret aversion.Types of Behavioral Biases that affect the investment decisions of investors:
- Confirmation Bias – Investors often do their own research before investing in any stock. During their research, they come across various pieces of information. However, due to their own confirmation bias, the investor will refuse to accept the information that confirms their already-held belief in an investment. Alternatively, if any information coincides with their investment expectations then they will readily accept it to confirm that they're correct about their investment decision even if the information is flawed. This leads to irrational decision-making. This can be overcome by treating all pieces of information in the same light to arrive at a logical conclusion.
- Loss Aversion – When investors try to avoid a loss more than recognizing market gains it is called loss aversion. Investors try to hold onto their loss-making stock in the hope of getting back to its initial price. They are hesitant to accept their mistake when the stock is making losses and hope for it to return to its initial price which causes deeper losses. But when the stock has made money they will sell it immediately and attribute the gain to their skill and expertise.
- Familiarity Bias or Ambiguity Aversion – This means the investor only invests in familiar stocks or investment types with which they have a history. As a result, the portfolio of such an investor is not diversified to mitigate risks.
- Bandwagon Effect Herd Mentality – Here the investor makes investment because many other people do the same. investors tend to mimic other investors by making investments in similar assets, even if it is unsuitable as per their investment objectives. Herd mentality is the cause of bubbles in stock markets.
- Anchoring - When the investors get attached to certain stocks and are slow to react to economic or market developments even in the face of changing information.
- Recency Bias – When the investors believe that the current situation will persist despite having any data to back that up.
- Overconfidence Bias - overconfidence bias makes investors overestimate their abilities leading to poor investment decisions. Overconfidence is a type of emotional bias. It can harm your investment portfolio, as you may make decisions under this bias without analysing the market scenario. It may lead an investor to make investment decisions, which are beyond their risk tolerance.
- Hindsight Bias – Here the investor believes that they correctly predicted a particular event in the past, which in fact they did not. This leads to overconfidence and the investor thinking they can also predict future events. Picking a stock based on how it has performed lately or fear of missing out on future gains.
- Regret Aversion - This is the natural desire to avoid regretting an investment decision. This regret may grow in proportion to the scale of any potential negative consequences.
- Self serving Bias - A self serving bias is a tendency in to attribute good outcomes to our skills and bad outcomes to bad luck. This often leads to bad investment decisions and repetition of such moves in future.
Overcoming Behavioral Finance IssuesAs we saw that an investor may have if not all but at least a few of these behavioral biases while investing. We, therefore, need to look at ways to overcome these negative behavioral tendencies in relation to investing. Behavioral finance theory can be used to help investors understand how their biases could alter their portfolio returns and to show them that their investment decisions shouldn't be driven by emotion, but rather by a coherent strategy.
How to Overcome Your Biases.
- In order to overcome the biases, ensure that you make informed investment decisions after making a thorough fundamental and technical analysis of the assets.
- Relying on reflexive decision-making i.e your gut, makes one more prone to biases and influences. On the other hand, logical decision-making helps to avoid such errors.
- Focusing on the process rather than the possible outcome will lead to better decisions because the process helps you engage in reflective decision-making.