Economic theory assumes that investors behave in a rational manner, but unfortunately this is far from the case in real life. Behavioural finance attempts to understand and explain how human emotions influence investors in their decision making. Below we have a look at the most common behavioural biases.
The fear of regret is one we are all familiar with – it’s the emotion you experience after realising that you made an error in judgement. Investors can become emotionally attached to the price at which they bought a share, and then avoid selling at a lower price in order to avoid locking in the loss. Investors can also feel regret when they considered buying a share (but didn’t) which has subsequently increased in value.
Mental accounting occurs when investors perceive various sources of money as being different from one other. This can take various forms, e.g.:
- When investors are willing to take more risk with money that they inherited (as an example) than money they earned through work, or
- When employees buy company shares out of loyalty, even if it is a bad investment and means they are overexposed to that particular share
This theory suggests that investors experience different degrees of emotion about profits compared to losses. For example, investors experience more angst about potential losses than the joy they would feel from an equal potential profit. This also partly explains why investors hang on to losing shares for too long.
Investors tend to chase performance, and usually buy shares just as they are peaking and about to reverse (think of Bitcoin). They mistakenly believe that the recent trend will continue.
Over- or under-reacting
Investors tend to overreact on good news, as well as bad news. They become overly optimistic when markets go up and overly pessimistic when they go down. This ties in with the previous behavioural trait of recency bias where too much importance is placed on the most recent events and it’s assumed circumstances will continue.
People tend to overestimate their own abilities (how many men think they are above-average drivers?), thinking they have superior knowledge. They believe they can accurately time the market which leads to excess trading, which results in increased trading costs.
Investors normally gravitate more towards information and sources that confirm or validate their personal beliefs. They attach more emphasis on the outcome they desire instead of looking at the issue objectively.
This occurs when investors are influenced by peers and follow the general trend, even if it is not in their best interest. The individual doesn’t want to be left out and follows the masses, instead of focusing on what would be in his/her best interest.
Understanding the biases above and being able to identify them will help you not to fall into the same traps. The key is to try and take the emotion out of decisions and design a strategic, concise investment strategy for yourself. Doing this will enable you to stay disciplined in your investment decisions and ultimately lead to better trading success.
Head of Trading and Portfolio Analyst
Stephan heads up Sharenet’s trading desk and is a full-time trader and portfolio analyst, also responsible for equity research across industries. Stephan developed his passion for the markets while working in the Stockbroking division of Standard Bank and is especially passionate about CFD trading. Stephan studied at the University of Stellenbosch and completed a BComm Honours (Business Management) with a focus in Portfolio Management and Bonds. He has also passed the JSE Equity Trader’s Exam, RE5 (Representative) and RE1 (Key individual) Exams as well as the Registered Persons Exams (RPEs) in order to give advice on equities.