Investor behaviour often deviates from logic and reason, and investors display many behaviour biases that influence their investment decision-making processes. Kent Baker and Victor Ricciardi describe some common behavioural biases and suggest the psychology of investing nofsinger pdf to mitigate them.
Why do investors behave as they do? Investor behaviour often deviates from logic and reason. Emotional processes, mental mistakes, and individual personality traits complicate investment decisions. Thus, investing is more than just analysing numbers and making decisions to buy and sell various assets and securities. A large part of investing involves individual behaviour. Behavioural biases in investing encompass many types. For example, cognitive biases refer to tendencies to think and act in certain ways.
A cognitive bias can be viewed as a rule of thumb or heuristic, which can lead to systematic deviations from a standard of rationality or good judgment. Some controversy still exists about whether some of these biases are truly irrational or whether they result in useful attitudes or behaviour. Understanding investor behaviour can inform investors about these biases and help them improve their decision-making processes in selecting investment services, products, and strategies. As a result of the financial crisis of 2007-2008, the discipline of psychology began to focus even more on the financial decision-making processes of individuals.
Few of these behavioural biases exist in isolation because deep interactions exist among different biases. Nonetheless, the following list represents some common biases facing investors but others may be equally important depending on the specific situation. Representativeness results in investors labeling an investment as good or bad based on its recent performance. Consequently, they buy stocks after prices have risen expecting those increases to continue and ignore stocks when their prices are below their intrinsic values. Investors should have a clearly defined analytical process that they test and retest in order to refine and improve it over the long run. The disposition effect is harmful to investors because it can increase the capital gains taxes that investors pay and can reduce returns even before taxes. This bias occurs when investors have a preference for familiar investments despite the seemingly obvious gains from diversification.
An implication of familiarity bias is that investors hold suboptimal portfolios. The act of worrying is an ordinary and unquestionably widespread human experience. Worry educes memories and visions of future episodes that alter an investor’s judgment about personal finances. Anchoring is the tendency to hold on to a belief and then apply it as a subjective reference point for making future judgments.