
Behavioral finance examines the influence of psychology on investment decisions. As this field has gained prominence over time, its insights can assist both you and your advisor in making more prudent long-term choices.
People often make cognitive errors such as heuristics and biases; behavioral finance provides insights into these errors so you can avoid making them.
Loss aversion
Loss aversion is a behavioral economic principle that refers to humans’ tendency to favor avoiding losses over acquiring equivalent gains. This bias causes many investors to sell winning investments too soon or hold onto losing ones too long, or implement overly conservative investing strategies which restrict investment opportunities.
Prospect Theory: An Analysis of Decision Under Risk by Kahneman and Tversky was an influential paper that first introduced loss aversion into behavioral economics. Their groundbreaking research proved that humans make decisions based on subjective evaluations of outcomes and risks instead of rational considerations alone.
Researchers have observed that penalty frames (such as “you’ll be a loser” and “you’ll get a fine”) can be more effective than rewards in motivating people to change their behaviors. Stickk, for instance, encourages adopting healthy habits by using penalties as motivation; the effect may depend on cultural background and personality traits of individual users.
Familiarity bias
Familiarity bias can be an immense hindrance when it comes to investing. It leads people to invest in only those companies or sectors they’re familiar with, often disregarding any risks involved. Therefore, it is vitally important that investors recognize this cognitive bias’s effects on investment decisions and long-term financial security.
One way to manage familiarity bias is through self-awareness and emotional intelligence practices, including being aware of when emotions emerge and being able to recognize sudden surges of investing decisions due to emotional turmoil. Another strategy would be assessing past investments regularly in order to see if familiarity bias played any part.
Behavioral finance has revealed that financial and investment decisions can often be heavily impacted by human psychology rather than quantifiable data alone. Understanding these influences is integral to successful investment markets – for instance if a lawsuit threatens your stock investment, experiential bias might influence you to sell early and reduce losses.
Confirmation bias
Confirmation bias is a psychological phenomenon in which individuals seek information that confirms their beliefs, which often means ignoring any contrary evidence and misconstruing it. Confirmation bias also has been known to encourage following others’ opinions blindly without critically considering them – this phenomenon known as herd mentality can have serious ramifications on investment decisions.
One theory behind confirmation bias suggests that it serves to maintain people’s sense of self-worth. Being shown up as wrong can be devastating to one’s sense of self-worth; so confirmation bias allows people to ignore information which contradicts their existing beliefs; this tendency becomes particularly prominent if it implies they lack intelligence – an indicator often used as a measurement of competence.
This proposition seems inconsistent with findings that show bias primarily fuels one-sided information processing and facilitates group alignment of intentions. Since our ancestral groups were likely relatively viewpoint homogenous, bias could potentially have an evolutionary disadvantageous impact.
Experiential bias
Own experience bias is a psychological phenomena that can sway investor decision-making, often to their detriment during times of crises or uncertainty. Investors rely too heavily on past experiences when making new interpretations; this behavior finance principle often causes them to misinterpret new information in a biased manner. Own experience bias poses major problems for financial markets in these conditions.
If you own stock that’s subject to litigation and a suit is filed against it, selling quickly to avoid losing money may seem like the better strategy; however, waiting until everything has been settled could prove costly.
Behavioral finance, an emerging field in financial research, attempts to shed light on real financial behavior by applying psychological, sociological, and neuroscientific studies to real investment decisions. Investors must become familiar with psychological influences in order to make sound investment decisions; by being self-aware, diversifying investments over time and keeping an objective perspective they can prevent cognitive or emotional biases from making a negative impactful investment decision.