[Investing] Behavioral Finance: How to avoid becoming your own worst enemy!

Summary

• Although humans are considered to be some of the most intelligent creatures in the universe, we are not always rational when it comes to investing. Our emotions and subjective wishes often play an important role in investment decisions.
• This is the importance of behavioral finance, which focuses on the study of various psychological factors and emotions that influence investors’ decision-making in financial markets.
• We will explore six major cognitive biases that affect investors and how to deal with them. Establishing a disciplined investment strategy is a great way to avoid cognitive biases, as it helps reduce the likelihood of impulsive trading or being manipulated by fear and greed.

What is behavioral finance?

Behavioral finance is a specialized discipline that focuses on the study of how individuals’ investment decisions in financial markets are affected by psychological factors. Behavioral finance combines psychology with an attempt to identify the biased behaviors that lead investors to make irrational investment decisions, and demonstrates that even if investors are informed that they have made unwise decisions, it is difficult to get rid of these wrong behaviors. A number of behavioral finance studies have shown that financial markets can also be affected by investors’ overly optimistic or pessimistic sentiments and deviate from fundamentals.

Common cognitive biases that affect investors’ decision-making abilities

Anchoring and adjustment bias: People tend to estimate the value of assets based on initial guesses or less relevant information, and they do not investigate new information as it emerges.

Overconfidence Bias: Having a high self-esteem can encourage irrational investment decisions and affect investment returns. People generally believe they are better than others, prompting them to trade more frequently, thus adversely affecting returns.

Investor shortsightedness: represents the impulsive behavior of investors driven by greed or fear. Social media platforms hyping the impressive returns on an asset can create a fear of missing out among investors.

Herd mentality: The mentality of blindly following the crowd makes people feel safe in the community. Purely imitating the decisions of other investors without conducting careful research can produce speculative booms (such as the Internet bubble).

Disposition effect: Investors sell profitable assets prematurely and hold losing assets for a long time. This is all because investors like the mentality of making more profits than losses, but end up losing more. Therefore, investors may pay a considerable price if the resolution effect is not addressed.

Status quo bias: Humans tend to feel that maintaining the status quo gives them a sense of security, which explains why many people prefer to hold cash rather than invest even if inflation gradually erodes the purchasing power of savings. In the financial market, the aversion to losing money can lead investors to be unwilling to take any risks, even if they know that these risks are worth taking.

main deviant behavior	How to deal with these biases
Anchoring and adjusting bias	1. Don’t try to address all deviations at once. Identify the two to three main biases that have the most influence on investment decisions and try to constantly correct these biases or behaviors.2. Avoid making hasty investment decisions, eliminate emotional factors from investment decisions, and establish a set of predetermined investment procedures or strategies. Adopt a regular investment strategy to plan a diversified investment portfolio by combining core investments (also known as “strategic asset allocation”) and thematic investments (commonly known as “tactical asset allocation” or “satellite investments”), and Review the portfolio regularly, and this strategy can bring good returns over the long term.3. Eliminate discretionary attitudes from daily trading and investing and stick to a long-term investment strategy. This can protect you from conscious and unconscious biases and prevent you from making impulsive decisions.
overconfidence bias
Investors are short-sighted
herd mentality
disposition effect
status quo bias