Behavioral Finance and Personal Biases

Behavioral finance is a field of study that analyzes the effects of psychology on investors and the financial markets. It tries to explain why investors often act against their own best interests, appear to lack self-control, and make decisions based on personal biases instead of facts/data. An excellent example of this would be the Reddit subgroup that went after Gamestop in early 2021. And while investors might take the Gamestop saga as a win, the incident is a perfect example of how irrational, biased, and emotional investors have the potential to move the markets. 

So, how can you make better investment decisions while minimizing emotions and personal biases? First, you need to understand that, as humans, we are prone to making economic and financial decisions based on emotions. This often leads to inaccurate judgments and beliefs, resulting in powerful cognitive biases. The first step to avoiding these biases would be adopting a strict framework that works only based on data or factual information. Your framework should aim to eliminate emotions from your decision-making process and minimize personal biases.

Common Behavioral Biases You Should Be Wary Of

As earlier mentioned, behavioral biases are unconscious beliefs that influence our decisions and understanding of money. And while there may be numerous of these biases in today’s market environment, these are some of the common ones:

• Self-attribution bias: This is where an investor believes that most of their good investment outcomes result from skill, and the negative results are caused by bad luck.
• Confirmation bias: Confirmation bias is prevalent among today’s investors. This is where investors pay close attention to information that confirms their investment beliefs and ignore all information that contradicts it.
• Mental accounting: Mental accounting refers to how people treat money differently depending on its source and what we think it should be used for. A good case scenario would be how most people spend windfall gains on luxury items but would invest that same money if they’d earned it.
• Overconfidence bias: The overconfidence bias is the tendency to perceive ourselves as better than we are. The problem with being too confident is that an investor will overestimate their abilities and knowledge, leading to rash or poor decisions.
• Herd behavior bias: The herd behavior bias is simply investors following the masses instead of making their own decisions based on facts or financial data.
• Loss aversion: This is where an investor concentrates more on avoiding losses than recognizing investment gains. Although sometimes this can be a positive trait, loss aversion means a lot more investment opportunities are missed while trying to minimize losses.

Check out the  24 Cognitive Biases That Are Warping Your Perception of Reality