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Even the smartest people can make irrational investment decisions. Behavioral finance examines how psychological biases and emotions affect investing behavior, frequently resulting in less-than-optimal outcomes. Knowing these psychological traps is essential to making smart investment decisions.
1. Overconfidence Bias
Overconfidence makes investors overestimate their information and forecasting capacity, and they tend to trade excessively while underestimating the risks. This overconfidence can induce people to ignore important information, resulting in wrong investment decisions.
2. Loss Aversion
Loss aversion is a tendency to prefer to avoid losses rather than to receive equivalent gains. This can result in holding losing investments for too long to break even, as opposed to cutting losses and rebalancing more efficiently.
3. Confirmation Bias
Investors tend to look for information that supports their current set of beliefs and dismiss information to the contrary. The confirmation bias may lead to perpetuating poor investment strategies and interfering with rational decision-making.
4. Anchoring Bias
Anchoring is when people over-rely on the initial information they come across (the “anchor”) when making judgments. In investing, it could be sticking to a stock’s past price, resulting in misplaced assumptions about its future performance.
5. Herd Mentality
Herd behavior compels investors to copy the behaviors of a large group, resulting in market bubbles and crashes. This is based on the understanding that the general group cannot be wrong and the decision might supersede personal judgment and analysis.
6. Sunk Cost Fallacy
The sunk cost fallacy is the continuation of an activity because of resources already spent (time, money, effort), even if it is no longer worthwhile. In investing, this may be the retention of a depreciating asset due to the value already spent, instead of looking at its objective current value.
7. Recency Bias
Recency bias causes investors to place excessive emphasis on recent events when considering investments. This can cause overreaction to short-term market movements and ignoring long-term trends and fundamentals.
8. Framing Effect
Framing effect refers to the way information is presented affecting decision-making. For example, framing an investment as having a “70% success rate” or “30% failure rate” can create varying perceptions, even though they present the same information.
STRATEGIES TO CURB COGNITIVE BIASES
- Awareness and Education: Acquaintance with general biases is the stepping stone to preventing their effects.
- Diversification: Investment diversification among assets can minimize the individual bias impact on the portfolio.
- Setting Clear Investment Objectives: Having set goals can serve to keep focus and minimize emotional choices.
- Regular Portfolio Reviews: Periodic portfolio reviews can correct biased investment decisions.
- Consulting Financial Advisors: Experts can give impartial advice and counterbalance individual biases.
CONCLUSION
Intelligence in and of itself doesn’t protect one from irrational investment decisions. By recognizing and appreciating the psychological biases that dictate behavior, investors are more likely to make sensible choices, which translates to improved monetary results.
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