With the markets being its typical unpredictable self, below we take a look at some of the most common behavioural biases. Economic theory assume that investors behave in a rational manner, but 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 process.
The fear of regret is one we are all familiar with and is the emotion experienced after you’ve realised that you made an error in judgement. Investors become emotionally attached to the price at which they bought the share. This usually happens when investors avoid selling at a lower price in order to avoid locking in the loss, or 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:
– Investors willing to take more risk with money that they inherited (as an example) than money they earned through work, or
– Employees that have stock options to buy company shares feel they are more loyal employees when they do, 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 with profits compared to losses. Investors experience more angst about potential losses than the potential joy they would from an equal 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 it is peaking and about to reverse (just think of Bitcoin). They believe mistakenly that the recent trend will continue.
Over- or Under-Reacting
Investors tend to overreact on good news, as well as bad news. They get 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 assumed it will continue.
People tend to overestimate their own abilities, thinking they have superior knowledge. They believe they can accurately time the market which leads to excess trading, resulting in increasing 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 it 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 aforementioned biases and being able to identify them will help you not to fall into the same traps. The key is to try and take emotion out of decisions and design a strategic, consistent investment strategy for yourself. Doing this will enable you to stay disciplined with your investment decisions and ultimately lead to more success with your trading.