Behavioral Finance is a relatively young field of study which analyzes how psychological factors influence investors and financial markets. Behavioral finance combines the fields of finance and psychology. Cognitive and emotional biases can lead to people making poor/illogical decisions regarding their finances and investments.
Following are some of the most common behavioral finances biases:
Attachment Bias is holding an investment for emotional reasons rather than for its objective likelihood to appreciate. Examples of this would be a person owning a stock solely because they work for the company, or refusing to sell a stock because it was inherited from a loved one.
Anchoring Bias is the tendency of investors to become fixated to a specific price as a baseline for the holding. For example, suppose ABC stock rose 25% to $100 per share on its first day of trading, and then subsequently fell to $70 per share – many investors who bought the stock on day one will hold to the belief that $100 is the fair value price – ignoring new information about the company and its progress. Anchoring bias occurs when an individual creates an arbitrary benchmark by relying too much on the initial information they had.
Confirmation Bias is the human tendency to accept and embrace information that agrees with or confirms our opinion, while minimizing or disregarding information that does not agree with us. It is the habit of seeking out information that fits our belief pattern, while resisting thoughts or evidence that are contrary to our position. Confirmation bias interferes with our ability to make objective decisions.
Hindsight Bias is the tendency to believe that we knew all along what was going to happen. After the fact, one “always knew” that they were right. For example, many people now claim they knew the housing bubble was about to burst – this can lead to investors becoming overconfident in their ability to predict the future, and may result in them taking large risks.
Loss Aversion Bias is the tendency for investors to avoid taking losses. Research has shown that investors generally feel the pain of a loss much more strongly than they feel the joy of making a profit. The reluctance to sell a losing position and then becoming too risk-averse after incurring a loss, frequently results in overly conservative portfolios.
Herd Behavior Bias is the tendency for individuals to mimic the actions of the larger group, and to follow the crowd (going against the crowd is typically uncomfortable). When “everybody” bought dotcom companies in the late 1990’s, the actions of the herd did not make it a good idea. History shows that the herd (all of us together) can make large mistakes. Herding behavior, combined with fear and greed, is often cited as the main reason behind bubbles and crashes.
Mental Accounting Bias involves looking at sums of money differently, or assigning it different classifications depending on its source or intended use. Mental accounting involves a person placing different values on the same sums of money. For example, viewing a tax refund or bonus as a windfall that can be used for extravagant spending (that was your money being returned to you, and money that you earned). Money is fungible – all money is the same and the sums are interchangeable regardless of where you got them or what they are used for.
Self-Enhancement or Overconfidence Bias is the tendency to place too much emphasis on one’s own ability, without recognizing the role of external factors. Overconfident investors often believe they are better than others at choosing the best investments and entry/exit spots. This may lead to excessive trading and heavy over-weighting of positions, which can translate into poor performance when things go wrong.
The goal of recognizing and understanding the above common behavioral biases is to help prevent psychological/emotional factors from negatively impacting financial and investment decisions. Being aware of biases can help investors avoid some of the classic mistakes.
Traditional financial theories/analysis/valuation techniques are not the only things behind investments decisions, and they don’t take into account human psychology. Behavioral Finance acknowledges that human investors are influenced by their assumptions, perceptions, biases, and emotions. Movements in the financial markets are determined by the actions of people, and behavioral finance plays a large role in that!
All the best – Southport Station Financial Management, LLC