The human mind is complicated and unpredictable. It is normal for a human being to be emotional and irrational. Unfortunately, this might be a piece of bad news for investors as a bad emotional decision might come back and bite you. Even the most successful man on the earth would have his own shares of weakness but knowing to channel the emotions towards one’s own advantage is crucial. This brings us to the topic of behavioral finance, a new branch of financial research that combines the psychology of decision-making with the decision-making models of standard finance theory.
Let’s take a look at the 6 common behavioral mistakes that need to be avoided.
- Fear Of Guilt :
The fear of guilt is something we all deal with on a daily basis. The fear of guilt makes you feel shame, sadness or remorse about the decisions you have made. While this itself is not very uncommon, it might cause to doubt your own ability to make decisions and will force you to take even more poor decisions. The fear of guilt also makes the investor procrastinate in making a decision. Studies have shown that investors tend to postpone making a decision claiming that they are waiting for a yet to arrive information release, even if the new information is not going to change their minds likely.
- Overestimation Of Abilities :
Another good reason for poor decision making is overestimating one’s own abilities. Plenty of studies have revealed that people regularly overestimate their own abilities. Studies have also shown that people tend to be overconfident about the reliability of the information. It should also be noted that men tend to be more confident in their decision-making more than women. If anything that could be done by the investors about this is to trade less. Putting too much faith in an analyst’s buy/sell recommendations might lead to excessive trading. Another reason why an investor could be overconfident is the refusal to rely on historical information and to focus on the present.
- Anchoring Bias:
During normal decision making, individuals anchor, or overly rely, on specific information or a specific value and then adjust to that value to account for other elements of the circumstance, and it is normal because the brain simplifies the complex tasks of information processing and decision-making. The concept of bottom-fishing could act as proof of anchoring bias. Bottom fishing is an investment strategy in which investors seek out securities whose prices have recently dropped and are considered undervalued. Bottom-fishing could end up dangerous because once the market sours on a stock, you could be in for a lot of pain. A good example could be Schlumberger (SLB).
- Refusal To Come Out Of Comfort Zone:
We all would want to stay inside our comfort zones since it is easier and humans naturally want to take the simpler, less risky route. Our comfort zone is a behavioral space that we tend to spend most of our time in. Investors turn out to be short-sighted in their choices about personal activities that involve losses. Since we all are emotional creatures, we would always want to avoid losses at any cost and this refusal to take risks might cost an investor a lot. This shortsightedness might be termed as myopic risk aversion.
- Confirmation Bias:
Confirmation bias is the tendency of people to favor information that confirms their existing beliefs or hypotheses. It’s when a person would not want to question his existing belief and would just go with the information that would match with their existing opinions and beliefs no matter how inaccurate it could be. This could also be termed as a psychological characteristic that is similar to the fear of guilt. For instance, john purchases a brand new camera and avoids advertisements of cameras from rival companies by seeking out ads of the camera he purchased. By doing this he protects himself from the pain of having purchased the wrong model. This implies that john will continue to make bad decisions and stick to the beliefs that match to his own.
- Representative Bias:
Representative Bias occurs when we make conclusions about a person or event that we already have in our minds that represents the said person or event. We form our own opinions based on what we have heard before. This is similar to confirmation bias. Investors tend to easily classify two companies that report poor results as poor companies with bad results but it might not always the same.
Mistakes are inevitable. There is no human who can never commit mistakes in his lifetime. Mistakes help you to grow and learn. Having knowledge about such blunders will help you succeed as an investor. Always make sure to have proper planning and a farsighted mind. If you plan to take risks always be prepared for it and don’t let your emotions come in your way.