Behavioral biases and how they impact investment decisions
By Anushreya Kondapi
As humans, we often trade with behavioral biases that cause us to act based on emotion. This is the basis of behavioral finance, a relatively new field of study that combines psychological theory with conventional economics. Behavioral finance predicts trading behavior and is used as a basis for creating more efficient trading strategies.
It is an emotional bias. It has two components: overconfidence in the quality of your information, and your ability to act on said information at the right time for maximum gain. Studies show that overconfident traders trade more frequently and fail to appropriately diversify their portfolio. The more active the retail investor, the less money they make.
Trade less and invest more. Understand that by entering into trading activities you are trading against computers, institutional investors and others around the world with better data and more experience than you. The odds are overwhelmingly in their favor. Resist the urge to believe that your information and intuition is better than others in the market.
2. Reducing Regret
You were confident that a certain stock was value-priced and had very little downside potential. You put the trade on but it slowly worked against you. Behavioural economists call it to regret. As humans, we try to avoid the feeling of regret as much as possible and often we will go to great lengths, sometimes illogical lengths, to avoid having to own the feeling of regret. By not selling the position and locking in a loss, a trader does not have to deal with regret.
Set trading rules that never change.
3. Limited Attention Span
There are thousands of stocks to choose from but the individual investor has neither the time nor the desire to research each. Instead of making the most efficient decision, they’ll make the most satisfactory decision. Because of these limitations, investors tend to consider only stocks that come to their attention through websites, financial media, friends and family, or other sources outside of their own research.
Recognize that the media has an effect on your trading activities. Learning to research and evaluate stocks that are both well-known and something creative might reveal lucrative trades that you would have never found if you waited for it to come to you.
4. Chasing Trends
This is arguably the strongest trading bias. Although financial products often include the disclaimer that past performance is not indicative of future results, retail traders still believe they can predict the future by studying the past. When they find a pattern, they act on it but often that pattern is already priced in. Even if a pattern is found, the market is far more random than most traders care to admit.
If you find a trend, it’s likely that the market identified and exploited it long before you. You run the risk of buying at the highs – a trade put on just in time to watch the stock retreat in value. Following the herd rarely produces large-scale gains.
THE BOTTOM LINE
Understand that the best way to avoid the pitfalls of human emotion is to have trading rules. Those might include selling if a stock drops a certain percentage, not buying a stock after it rises a certain percentage and not selling a position until a certain amount of time has elapsed.