Behavioural finance recognizes how emotions such as greed and fear can have an influence over investment decisions. By acknowledging these human responses as deviations from traditional principles of finance, and leading to suboptimal investment decisions.
Emotion management can help you make more rational and consistent investing decisions. Seeking personalized financial advice or using dollar cost averaging can also be effective ways of combatting investor biases.
Greed
Greed is defined as an insatiable desire for more, which has long been perceived as being harmful. However, studies have demonstrated that greed may actually have beneficial outcomes for society and individuals when used strategically rather than fleetingly [10].
Investors must be wary not to succumb to emotions when making financial decisions, whether that means investing in the latest “get rich quick” scheme or exiting when the market drops irrationally, such behaviors could damage your portfolio and lead you away from important opportunities. Therefore, it’s essential that investors develop an emotional-based investment plan supported by solid, objective financial data – something which may not always be easy but essential for successful investing. One way this can be accomplished effectively is focusing on goal-based investments rather than looking solely at returns (high/low).
Fear
Folklore holds that greed and fear drive the market. Yet research demonstrates otherwise. While both emotions certainly influence investor decisions, their impact may differ significantly; most investors hope for hope over greed when making financial decisions.
Avoiding loss weighs heavily on most people, even when its chance is slim. Investors with fear of loss typically opt for safer investments such as U.S. Treasury notes rather than higher-return investments that involve greater risks; this tendency is known as loss aversion.
People tend to rely heavily on one source of information when making future judgments, affecting how they make future decisions. When investing, this can mean being influenced by initial price at which you purchased stock or round numbers on market indexes; this behavior, known as anchoring, can cause errors such as overestimating returns or taking too much risk in portfolio returns and takes.
People in a good mood tend to overestimate the probability of positive outcomes and underestimate those which could go against them, so as an investor you should always factor in any incidental emotional states unrelated to the decision at hand.
Overconfidence
Overconfidence can cause investors to think they know more than they actually do about the market, leading them to take unnecessary risks or trade too frequently and lose money. Furthermore, overconfidence makes people more susceptible to investment fraud.
Not just wealthy investors are vulnerable to overconfidence bias; anyone with some level of expertise can be affected. Friends who consistently pick winners in football games could be suffering from it too, leading them to make reckless predictions that can create bubbles.
Research shows that overconfidence can be curbed by compelling people to consider disconfirming evidence, as well as forcing them to compare their predictions with those of others (recalibrating). Another effective strategy for combatting overconfidence bias is visualizing an investment from its future perspective and considering why it might fail – an approach developed by Gary Klein and later endorsed by Nobel laureate Daniel Kahneman is one such technique for doing just this.
Loss Aversion
Loss aversion plays an integral role in investment decision-making, often overriding other considerations and leading to riskier investments than they otherwise would be. Investors tend to focus more on mitigating risks than realizing returns – this may cause them to invest in doomed products even when there are reports to support them or cause them to sell winning stocks too soon.
Dan Kahneman and Amos Tversky conducted a landmark behavioral finance study that demonstrated how individuals tend to weigh costs more heavily than benefits due to people being more sensitive to potential losses than potential gains; many estimates indicate they weight potential losses twice as heavily than potential gains.
To counter this, work with your clients to develop objective guidelines for buying and selling that enable them to make more rational decisions despite market volatility, and reduce psychological traps that they may fall into.
Aggression
Aggression can have a powerful influence over investors, leading them to make impulsive and irrational choices which result in financial losses and negatively affect market prices. Studies in behavioral finance have identified numerous psychological factors which impact investment decisions and may contribute to aggressive behaviors among investors.
One such bias is representativeness bias, where individuals incorrectly assume that when events unfold in a particular sequence they have significance. For example, when flipping coins most people tend to believe HTHTTT will follow HHHTHT, instead of likely happening more frequently as would occur with other outcomes such as HHHTHT or HHHTTT.
Another guileful fallacy is the gambler’s fallacy, where people incorrectly assume a series of events is caused by random chance alone, for instance when investments show good and poor performances respectively. This can lead to overtrading, as well as misattribution of investment success to own skill and attribution of poor performance to outside influences; it is therefore wise to seek diverse sources of information and communicate ideas freely with others so as to avoid these traps and their pitfalls.
