Behavioral Finance

Behavioral Finance – Investing Psychology | How to avoid the cognitive biases

Table of Contents

What is the concept of Behavioral finance?

Behavioral finance is a subfield of behavioral economics. It proposes that psychological influences and biases affect the financial behavior of investors. These influences and biases can be the source for the explanation of all types of market anomalies specifically those in the stock market, such as severe rises or falls in stock price. Some common behavioral financial aspects include loss aversion, consensus bias, and familiarity tendencies.

This article covers some of the most important cognitive biases. Awareness and control of these biases are essential for success in the stock market, or any other market

Loss aversion 

What is Loss aversion? 

Loss aversion is a cognitive bias describing the human tendency to strongly prefer avoiding losses over acquiring equivalent gains. In behavioral economics and decision theory, this bias highlights how individuals feel the pain of losses more intensely than the pleasure of equivalent gains.

Studies suggest that the emotional impact of losing something, such as money or possessions, is typically about twice as powerful as the pleasure derived from gaining the same amount.

This asymmetry in emotional response leads individuals to make decisions that prioritize avoiding losses, even if it means forgoing potential gains or taking unnecessary risks.

How to avoid loss aversion?

Education and awareness: Understanding the biases affecting decision-making processes is the first step. Educating oneself about loss aversion helps investors recognize and mitigate its impact.

Recognizing this bias is crucial for investors to make more rational and informed choices. Mitigating its effects involves adopting strategies like education, long-term focus, diversification, and setting clear objectives to make more objective investment decisions.

Anchoring Bias

What is Anchoring Bias?

Anchoring is one of the most common cognitive biases that affect investors. Anchoring is the tendency to rely too much on the first piece of information that we receive and use it as a reference point for making subsequent judgments

Examples of anchoring bias:

Anchoring to historical prices – It is common to consider 52 weeks high and low of stock to estimate its current value. If a stock is trading at a discount to its 52-week high, it does not mean that it is trading at a cheap price. If the fundamentals of the stock are not strong, or the underlying business does not have a promising future, the stock might further dip and not return anywhere near its 52-week high value.

Anchoring to arbitrary numbers – People often anchor the projected value of a stock to a round value. If an asset is trading at 2800, they assume it will touch 3000 soon. This leads to a tendency to overinvest in an asset without proper analysis.

Anchoring to expert opinions – Before watching a movie, people watch expert reviews and anchor their expectations to it.The reviews are the opinion of the experts based on their tastes and subjective views. Anchoring the expectations to such reviews often leads to disappointment or surprise. 

Anchoring to personal experiences could lead to exiting a promising trade early without realizing the full gains or staying with the trade despite all evidence suggesting the opposite. 

How to avoid anchoring bias?

Anchoring is a natural and pervasive phenomenon that can affect anyone, regardless of their level of expertise or experience. However, some strategies can help investors overcome this bias and make better decisions.

Critical Thinking – It is common for the investors to anchor the stock price to a predetermined value, and then seek validation for the same. Thus, anchoring bias leads to confirmation bias. Such anchoring happening over a large scale may also lead to herding effect. This is common with cryptocurrency investing. This could be avoided by critical thinking and not letting an unrealistic anchoring value determine the investing decisions. 

Seek multiple sources of information– People often base their investment decisions on the stocks recommended by experts or restrict their fundamental analysis to considering a few key ratios. To increase the probability of picking a winning stock, investors should seek more information like analyzing the annual reports, following the industry news, and other updates about the stock. If the required information is not available, one can also follow the Scuttlebutt approach.

Review the investment frequently– Warren Buffett opined that investing in a stock is equivalent to owning a business. One should not restrict their focus only to the point of entry-exit. Investors should take an interest in all the relevant information that is available. Based on the assessment, one should decide whether to stay invested or opt-out. 

Overconfidence Bias

What is overconfidence bias?

Overconfidence bias is the tendency of a person to overestimate their abilities. It may lead an investor to believe that they are experts. A wealth of easily available online info, anecdotal evidence, and luck in random investments may encourage an investor to put excessive faith in their expertise. 

Psychologists suggest that overconfidence bias is related to people’s need to maintain a positive self-image. They argue that people tend to engage in self-enhancement strategies, such as overestimating their abilities, to protect their self-esteem. 

Overconfidence bias can lead investors to believe that they have an edge in the market and that they can consistently outperform it. This can lead them to take on excessive risks, such as investing heavily in a single stock or sector, and to ignore the importance of diversification.

How to avoid overconfidence Bias?

There are several strategies that investors can use to mitigate the impact of overconfidence bias on their investing decisions. One effective approach is to seek out diverse perspectives and feedback from others, such as financial advisors, peers, or experts in the field. This can help investors gain a more balanced and objective view of their investments and avoid making decisions based solely on their own subjective beliefs. 

Another strategy is to use data and evidence-based analysis to inform investment decisions, rather than relying on gut feelings or intuition.

Herd Mentality

What is herd mentality?

In behavioral finance, herd mentality bias refers to investors’ tendency to follow and copy what other investors are doing. They are largely influenced by emotion and instinct, rather than by their independent analysis. Due to this, many people act in the same manner at the same time. 

Examples of herd mentality

Movie reviews – People often decide to buy movie tickets after following the opinions of other people, which are available in plenty in the internet era. There is also a tendency to dismiss a movie or shower praises on it, without watching, based on the opinion of others. These opinions may not be genuine due to confirmation bias, where people already make up their minds influenced by other factors associated with the movie.

Stock Market – In the stock markets, herd mentality manifests in the form of volatility. The prices suddenly increase or decrease because many people try to enter or exit the market at the same time. Everybody follows the herd assuming the trend to be correct, since a large number of people are already following it. Not many check the facts and underlying fundamentals of the business. Many Market bubbles are formed, and crashes happen due to herd mentality. 

What causes Herd mentality?

Lack of Information – People who do not invest time in analysis often let others dictate their investment decisions. When the market is at its peak, they invest, and when the market is falling, they exit the trade.  

Avoidance of risks – Investors who follow the herd often have risk aversion. Risk aversion leads to investors not trusting their judgment and prefer investing in safer stocks where others are also investing. Thus, they are not able to enter a promising trade not discovered by others during the early stages and derive big gains from it. 

Avoiding herd mentality

People should make their own decisions based on objective analysis and rational thinking rather than following the herd. If done in the right way, investors could benefit from the bubble caused in the markets due to the herd mentality.

Confirmation Bias

The tendency of people to pay close attention to the information that confirms their belief and ignore information that contradicts it

Examples of Confirmation bias?

Political beliefs – Many people watching daily NEWS are not interested in knowing the facts. They watch only the NEWS channels that support their favorite leader and confirm their prejudice and bias.

Movie reviews – Many fans wait for the early movie reviews of their favorite actors or directors. This is not to know the merits of the movie but to confirm that the movie has met the expectations. Positive reviews are accepted and forwarded to others. Mixed reviews are dismissed as biased. 

Investment– Instead of dedicating time to fundamental analysis and research, the investors spend disproportionate time reading positive articles, and optimistic five-year or ten-year projections of the stock.

Competitive examination – In competitive exams, it is a tendency of aspirants to google the answers to estimate their scores. Despite knowing the answer is incorrect, there is a tendency to keep googling till they find some glimmer of hope that there is a slight probability of the answer being correct. 

What causes Confirmation Bias?

Confirmation bias can cause problems, but many times it seems to make life temporarily easier too. Following are some of the causes:

Alleviates stress – Confirmation bias helps in overcoming the stress of being wrong. Assume one has invested in the wrong stock. Searching the internet for supporting information helps in reducing stress temporarily. 

The same goes for academics. If searched with dedication, any answer marked in the OM sheet could be proved correct. It does not change the outcome though.

Helps self-esteem – No one likes to be proven wrong. If any information is presented that conflicts with our beliefs, it is only natural to push back. Disproving the deeply held views can be uncomfortable. A reality check can cause discomfort. The shortcut adopted by the brain to avoid this by confirmation bias. 

How to avoid Confirmation bias?

One must diversify the source of information and look at the pros and cons of the subject at hand. This enables getting a well-rounded opinion before making the final decision. Additionally, one must engage in debates, or rationally view the opinion of others with contrasting views.

One should also review the past decisions. If they were given the chance to go back, are they going to make the same decision again? Self-reflection, asking questions, and looking for solutions rather than answers that conform to our opinion are the keys to avoiding Confirmation bias.

Framing Effect 

What is Framing bias?

Framing bias happens when people make decisions based on the way the information is presented as opposed to just on the facts themselves.

The same facts presented in two different ways can lead to people making different judgments or decisions

Examples of Framing effect

Different benchmarks – Consider the following two options:

Option 1: In Q3, the net sales jumped by 15% over Q2. EPS performed even better with 20% growth over Q2.           

Option 2: In Q3, the net sales dropped by 5% and EPS dropped by 7% compared to Q3 last year.

Option 1 does a better job of framing the sales and earnings report. The way it is presented – as an improvement over the previous quarter – gives a positive image of the company’s performance, though both the options share the factual performance of the same company. 

What causes the Framing effect?

We all fall prey to the framing effect. We are presented with hundreds of choices each day. And our brains want to make decisions efficiently without having to use up too much brain power.

According to psychologists, our cognition processes are divided into two modes of thinking:

(i)System 1 thinking – Intuition which produces quick and associative cognition, and

(ii) System 2 thinking- Reason, described as slow and rule-governed.

In system 1 thinking the simple ideas travel quickly. It takes little time and not much intellectual work.

System 2 is the reflective part of our cognition process. It operates in a controlled manner. Our slow-moving ideas that require reflection, judgment, and special expertise are housed in System 2 thinking. 

System 2 is so distinct from System 1 thinking that Psychologist Keith Stanovich has termed the two as having separate minds. 

Framing effect is the result of myopically viewing things. People are not accustomed to System 2 thinking and rush to find a plausible answer by engaging in System 1 thinking. System 2 thinking which involves a deeper view, expertise, and judgment is not employed by most people. Those who put the effort into deploying System 2 thinking are less vulnerable to letting the Framing effect impact their decisions.

How to avoid Framing effect?

To avoid Framing effect impact on the decisions, people must ensure they properly investigate all the options. They must strive to seek maximum knowledge about the subject by asking questions and referring to the available information sources. The tendency to quickly make decisions without deep diving into the available details should be avoided. 

Recency bias 

Whatis Recency Bias?

The tendency of investors to put more emphasis on recent events potentially leads to short-term decisions that may adversely affect long-term plans. It is overemphasizing the importance of recent events or experiences in determining the future outcomes. Short-term memory, also known as active or primary memory, is the ability to hold a small amount of information in the mind for a brief period.

What causes Recency Bias?

Recency bias happens because the events that have happened recently are still stored in the short-term memory and are easy to recall. 

Thus, association of such recent events with some future events does not take much effort, and mostly it happens naturally. Due to recency bias, investors often buy at high and sell at low. It leads to losses and loss of opportunity.

Recency Bias examples

Recent Experience– Someone who was recently involved in a road accident would likely be more careful crossing the road sometime soon. 

Someone not fond of watching horror movies might struggle to sleep for a few nights after watching one. 

Jaws – After Steven Spielberg’s 1975 classic Jaws, many people feared going for the ocean swim, despite the infinitesimally small probability of being attacked by a shark.

Bitcoin wave – Recency bias also induced many people to ride the bitcoin wave in November 2021 when it peaked at $64K. To their misfortune, the Bitcoin plummeted to around $16K by December 2022. Many people lost hope in Bitcoin by December 2022 and exited booking heavy losses. To their dismay, Bitcoin bounced back to hit an all-time high again of close to $70K by March 2024.

How to avoid recency bias?

Recency bias happens when people anchor their behavior and decisions to a recent event. 

Some recency bias like being scared of ghosts after watching horror movies or avoiding going near the ocean after watching Jaws takes time to weaken. Self-awareness, a strong understanding of the fundamentals, and rational thinking are the keys to controlling it in most cases.

Endowment effect 

What Is the Endowment Effect?

The endowment effect refers to an emotional bias that causes individuals to value an owned object higher, often irrationally, than its market value. The term endowment effect was first used by the economist Richard Thaler. It was used in reference to the inertia related to consumer choices when goods included in their endowment were more highly valued than goods that were not.

This type of behavior is typically triggered by items that have an emotional or symbolic significance to the individual. However, it can also occur merely because the individual possesses the object in question. The endowment effect makes investors hold onto specific securities longer than they should. 

What causes the Endowment effect?

Research has identified two main psychological reasons as to what causes the endowment effect:

Ownership: Studies have repeatedly shown that people will value something that they already own more than a similar item they do not own. It does not matter if the object in question was purchased or received as a gift; the effect still holds. The assumed value of the object rises if the emotions or symbolic significance are attached to it. In such cases, even a price far higher than market value may not convince the owner to sell the item. 

Loss aversion: This is the main reason that investors tend to stick with certain unprofitable assets, or trades defying all logic and rational thinking. The prospect of divesting at the prevailing market value does not meet their perceptions of its value. This is different from holding a stock after thoroughly analyzing it, something that is advocated by prominent investors like Warren Buffett, Charlie Munger, and many more. 

Recency bias: An investor may have bagged some profit after a temporary loss recently and expect the same turnaround again. This tendency to overestimate the value of an owned item, and set wrong expectations based on a previous result is common. 

How to avoid the Endowment effect?

If the concerned item has a symbolic significance or emotions attached, it is hard to avoid the Endowment effect. For the other cases, it could be avoided by:

Rational thinking: In the case of equity investments, holding or selling should be governed by rational thinking backed by in-depth fundamental analysis. 

Regular updates: Investors must educate themselves about all the aspects of the stock. They should follow the latest NEWS, expert opinions, and future growth potential. They could also use Scuttlebutt to research the stocks to obtain the information not available otherwise.

Mental Accounting

What is Mental Accounting?

Mental accounting is the tendency of humans to create mental labels for money, based on its origin or deemed purpose. Money itself is interchangeable, but through mentally dividing it into labels, we don’t see it that way. Although these decisions can seem rational, they are often governed by emotions and can be misleading or even damaging.

Without mental accounting, a person would need to consider all of their present and future wealth, before deciding whether to go out for dinner. This process would be unsustainably time- and energy-intensive, so our brains invented mental accounting as a shortcut.

Causes of Mental Accounting

There are several reasons that our mental accounting processes lead us to make bad money decisions. These reasons are all rooted in the fact that we tend not to think of value in absolute terms. Instead, an object’s value is relative to various other factors.

One of the core properties of money is that of fungibility, meaning that it is made up of units that are all interchangeable and indistinguishable from one another. Money is fungible because a dollar is worth the same no matter where it came from or how it is spent. Additionally, money doesn’t come with any labels; the same dollar that you put towards your morning coffee could also be spent on a bus ticket or put towards a new dress.

Many studies have shown that people tend to label additional income either as “regular income” or as a “windfall gain.” What’s more, people are more likely to spend windfall gains than regular income—and are more likely to spend them on luxury goods than essential ones.

How to avoid Mental Accounting bias?

Windfall gains often end up being spent on spur-of-the-moment purchases. Tax returns are a good example. Even though we know to expect a tax return every year, we never know exactly how much it will be. We tend to spend the extra cash received.

To avoid this, one should figure out a strategy for unexpected income, like tax returns, gifts, and bonuses. For instance, one might decide to put a part of that tax return money into a savings account, invest some part, and use the rest for treats.

Regret Aversion 

What is regret aversion bias?

An investor is said to be suffering from regret aversion bias when he/she refuses to make any decision because of the fear that the decision will turn out to be wrong and then may later lead to feelings of regret. The emotional process behind this is pretty simple. Regret causes emotional pain. Hence, the brain tries to avoid making decisions that cause regret.

It is important to understand that investors can make two different types of errors. On the one hand, they can make a decision which turns out to be wrong. This can be called an error of commission because some action has been committed by the investor. On the other hand, an investor can simply miss out on a great opportunity by not taking any decision. This can be called an error of omission because of the lack of any action from the investor.

In financial terms, an investor may be likely to lose the same amount of money either by commission or by omission. However, when it comes to psychological terms, the commission error has a much higher chance of inducing regret. This is because regret is usually associated with a responsibility for an action taken. This is the reason that in case of regret aversion, no action becomes the default response of the buyer

Impact of Regret Aversion Bias

Regret aversion does not affect a person in isolation. It makes people vulnerable to other biases as well. Here are a few possible impacts of regret bias

Herding Effect: Despite the Regret aversion, the investor might still invest. People who experience a lot of regrets are often not sure of their own decisions. So they try to seek validation in the decisions made by others. Rather than doing their research and analysis, they trust others to dictate their investment decisions. 

Loss aversion and conservatism: Loss aversion in many cases is a by-product of risk aversion. A person apprehensive of regrets is likely to have less tolerance for loss. Such investors become conservative and do not take a chance on lesser-known stocks with promising fundamentals. Thus, they do not benefit from investing in a business during the initial stages and realize big gains from it. 

Growth as an investor: Profits and losses are part of the investing game. The greatest of investors have all made mistakes, learned from them, and won the race in the long run. Investors susceptible to regret aversion likely do not trust their ability to pick a stock with a high probability of success. Warren Buffett, a proponent of long-term investing, advised investors to not be bothered by short-term market fluctuations. A fall in the price of stocks with good fundamentals is an opportunity to buy more at lower prices.

How to overcome Regret Aversion?

The real problem with risk aversion is that it causes people to invest too conservatively. Hence, investors need to be aware of this bias and make appropriate investing decisions. A couple of strategies to help do so have been listed below:

Knowledge and Patience: The investor must understand that a stock is picked based on the probability of success. This probability could be increased by thoroughly researching the stock before the investment. If the fundamentals of a stock are strong, and if it is bought at a fair price, it has a high probability of navigating the market during tough times and performing well during bull runs. Being patient during tough times and trusting the quality of research work done for picking the stock, has favorable odds of success in the long term. 

Long-Term View: It is important to have a long-term view of the investments. This means that investors should keep in mind that a well-diversified equity portfolio is fairly safe and provides decent returns in the long run. This will help them overcome their regret aversion. 

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