Investing is a complex endeavor, with investors often grappling with emotions like fear and greed as well as following trends or holding onto unreasoning beliefs.
Understanding psychological biases is integral to successful investing. The field known as behavioral finance examines how investors’ mental tendencies can alter investment decisions.
The Illusion of Control
Investing can be a roller coaster ride. At times it feels exhilarating as your investments skyrocket upwards; at other times it feels dispiriting as they tumble downward at speed – all to quickly leaving you watching hard-earned funds evaporate like water off a surface.
Investors may fall prey to illusion of control bias, which is a cognitive bias in which individuals believe they exert more control over outcomes than is actually the case. This can lead to irrational decisions like overtrading and market timing that can harm returns and have serious repercussions for investors.
Herd mentality can also exacerbate the illusion of control, inducing investors to follow other investors despite whether or not their behavior is rational. This tendency can become particularly troubling during times of low liquidity such as during crisis situations or market crashes. Therefore, it’s crucial that when suffering from the illusion of control you consult a financial advisor with an objective perspective who can offer a more rational viewpoint.
“Buy low and sell high” is an oft-repeated maxim in investing. While this principle might seem straightforward, most investors find it challenging to stick with this practice due to emotional and cognitive barriers that impede investment decisions.
Loss aversion, herding and recency bias are among the key obstacles facing investors today. Investors with loss aversion may sell off investments during market downturns even when logic and research support holding or buying additional of those assets – this can lock in losses while missing future gains.
Make financial decisions based on sound principles rather than emotion, using strategies like automatic investment deductions or working with a financial advisor. If your investments become emotionally charged, take a step back from them to identify any driving emotions – this can help control investment behavior and reach long-term goals more successfully. Investing without emotion is often challenging but must be achieved for optimal success.
Loss aversion refers to our tendency to perceive losses as greater than gains at any level of risk-taking. It forms part of prospect theory developed by Nobel Prize winner Daniel Kahneman and Amos Tversky and helps explain why people prefer keeping what they have rather than abandoning courses of action once time, effort and money have been invested in them.
This leads to the’sunk cost fallacy, where investors are reluctant to cut their losses even when this would lead them to greater gains, as was seen with Nick Leeson’s trading at Baring’s Bank, which ultimately lost PS2.3b.
Prior losses directly influence investor decisions about investment objectives to achieve higher expected returns, while they indirectly have an effect on building a financial reserve for future expenses. This mediation effect can be modulated by investor risk tolerance; its size suggests the necessity of including loss aversion and risk tolerance into investment models.
Cognitive biases are mental shortcuts that lead to errors in judgment and decision-making, impacting everything from social decisions to investing decisions. Examples include anchoring, where we place too much weight on the first piece of information we receive; the halo effect, where people assume an attractive person must also be smarter, funnier or more ethical without sufficient evidence; or hindsight bias, where we attribute past successes solely on our skills rather than luck.
Your best strategy to combat cognitive biases is educating yourself on them, becoming aware of your personal vulnerabilities to them, and recruiting a diverse team with various backgrounds and expertises who can help identify alternatives you might overlook. Debiasing techniques like reference class forecasting may also reduce their effects.