Behavioral Finance Defined
Behavioral finance examines a relationship between cognitive and emotional response, and the particular actions of investors.
The rationality of investors, according to traditional financial theory, dictates that investors make best possible use of available information in making their investment decisions solely with a view to maximizing returns.
But what behavioral finance points out is that investors are mostly shaped by emotions, biases and irrationality in their trades.
Hence, an understanding of these psychological factors that work on our mind while making the decisions must be helpful to the investor to refrain from such pitfalls and design better mechanical-only plans for investments.
Contents
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- Fear And Greed: The Emotional Drivers
- Overconfidence Bias
- Loss Aversion Theory Of Loss And The Feeling Of Losing
- Herding Behavior Employment and Market Hypes
- Confirmation Bias: Seeking Validation
- Anchoring: The Role Of First Impressions
- Regret in Investment Making
- Conclusion: Emotional Intelligence And Its Application
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Fear and Greed: The Emotional Drivers
Greed and fear are among the most compelling feelings surrounding the idea of investment.
Self-interest is the explanation for why individuals have consistently searched for big gains with little concern for the returns and lack of self-interest is the explanation for why investors constantly bail out at the worst of times.
Emotions that make people invest at high end and sell their stocks at the lowest give bad results in the long-term.
For instance, in the boom of dot-com bubble many investors purchased tech stocks at an over inflated value owing to greedy that was out of missing gains and in losses when the bubble burst.
It is critically important to take into account such psychological factors as fear and greed in the search for sustainable profits.
Through this way, any investor I would have pointed out that the above mentioned emotions affect the ability of an investor to take wise decisions so that one has to remain disciplined to the recommended investment plan.
Overconfidence Bias
Overconfidence bias includes formation of the overconfidence belief that the investor possesses special knowledge of markets.
It results in overtrading, high risk-taking, of holding a losing position longer than necessary.
The unsound and exuberant investors overemphasize the control of market prospects and underemphasize the environmental factors that may affect the market.
This leads to taking wrong decisions that affect the returns in a negative way.
To the above, investors need to counter overconfidence through a constant check on the portfolio, critical analysis of decisions made and embracing diverse opinion.
Those same sources of protection against overconfidence can also include consulting with professionals and also maintaining a diverse investment selection.
Loss Aversion Theory Of Loss And The Feeling of Losing
Loss aversion relates to the observation where investors have a higher sensitivity to lose than they appreciate the gain.
It had been estimated that the cost or feeling associated with the loss is far worse than the benefit that a person can derive from the gain.
This fear can cause investors to eradicate risk all together even though this could mean the rewards for the investor are much higher.
On the other hand, loss-averse investors stay put with losing stocks with the hope of making a recovery, despite the fact that the investment once again becomes unprofitable.
To make good decisions, investors should not be swayed by tricky fluctuations in the market and they should keep their eyes on the long-term horizon.
Implementing predetermined targets in an investment portfolio already on the decline will ensure investors are more disciplined in the process.
Herding Behavior Employment And Market Hypes
Herding is brought about in a situation where investors will mimic other investors instead of making their own research or analysis.
This behavior stems from what we can call Cognitive FOMO, or the feeling that “everyone else” must know something that they do not.
Herding can cause effusion of stock asset bubbles through frenzy investment since investors follow the stock of popularity till it hits the other extreme of correction.
Other recent cases of herding behavior are the cryptocurrency and the recent so-called meme stocks.
The market trends should not be followed and every investment decision should not be taken based on the trends in the market.
To avoid the pitfalls of herding, a best course of action include researching on individual capacity, concentration on the basic fundamentals and practicing long term investment principles.
Confirmation Bias: Seeking Validation
Self-serving bias takes place when investors look only at the information that supports their view while ignoring information that they do not want to see.
It could cause investors to cling on to bad stocks or make decision with inadequate information.
For instance, an investor who invested heavily in a specific stock may only look at the bright side whereby the company he invested in is concerned while at the same time failing to look at red sign that may depict the company is headed for doom.
To deal with confirmation bias, investors have to go over their information with a fine-tooth comb; this includes trying to get different views and think of the other possible outcomes.
There is always the possibility of reinforcing understanding based on proper assumptions or learning and then questioning such information in order to make better decisions on investments.
Anchoring: The Role Of First Impressions
It refers to the tendency of investors to place undue reliance on what is received first about the value of an investment without revising that information as new information becomes available.
For example, suppose an investor bought a share at $100; they would not be willing to sell the share at $90 even if fresh information confirms that the share price will continue to drop.
The first cost provides the “reference point” which influences subsequent decisions.
To overcome the problem of anchoring bias investors must not dwell on the previous performance of an investment or its initial cost, but its real value at that particular time.
Adjustment of basic assumptions of every investment will guarantee that any decision made is useful in the current conditions rather than old conditions.
Regret In Investment Making
Losing focus is one of the most common emotions in getting in investment, and people often tend to regret what they did not do or should not have done.
Forgetting each great opportunity comes with some regrets which may cause ‘analysis paralysis‘ by which investors delay their decisions due to fear them making the wrong decisions.
On the other hand, regrets make the investors to rush into the market in a presented effort to try and recover the lost cash.
He adds that investors must understand that their investments come with certain levels of risks and hence one is bound to make some wrong decisions.
They should avoid regret making decisions or rather allow it lead to severity while they should follow their decision making processes as they follow their rational and logical thought processes.
Conclusion: Emotional Intelligence And Its Application
This paper shows that feelings and psychological factors mostly influence the decisions made by investors despite being rational.
By analysing behavioral finance, one can learn how to overcome tendencies that affect investment decisions in the market.
Being disciplined, staying on course, and keeping portfolio reviews in perspective should keep investors from getting their feathers ruffled all that easily.
Behavioural finance gets to understand why people invest as they do and how to keep off certain things that reduce the value of investors’ money.
We hope you enjoyed this article on behavioural finance.
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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
Original source: https://optionstradingiq.com/behavioural-finance/
