Behavioral Finance in Investing

Behavioral finance studies how the financial markets and the people inside, the investors, are influenced by psychology (Kaplan Financial Education, 2021). This definition relates to why although people have done a good analysis of their investments, they still tend to make irrational decisions. This is caused by the cognitive biases that will result in things such as acting against our best interests. We will further discuss what cognitive biases are there.

The first one is confirmation bias. Confirmation bias is when information is interpreted as how we believe the particular event should be. In other words, it is the inability to separate oneself from subjectivity. For instance, negative news regarding a company may be ignored after the person has committed to owning shares in the company (Aguilar, 2021).

The second one is experiential bias. Investors’ memories of recent occurrences create biases for them to assume that the event is far more likely to happen again (Hayes, 2021). This bias can be seen in the Global Financial Crisis (GFC) in 2008. The experiential bias created a view where people expected economic downturns in the following year. However, it turns out that the economy recovered.

The third one is loss aversion. If you ever experienced when your stock gains 10% and you feel just fine, but when your stock drops the same percentage, 10%, you immediately panic. That is loss aversion. Simply put, loss aversion is when the psychological anguish of losing is twice as strong as the pleasure of gaining (The Decision Lab, n.d.).

The last one is familiarity bias. As its name implies, this happens when even though other acceptable possibilities can also be added to increase portfolio diversification, an investor prefers a known investment (Kase, 2018). This may affect the portfolio performance as a familiarity bias portfolio will tend to be less diversified. An example is when one’s portfolio is too heavy on specific sectors because they thought they were more familiar with it. It can also be the opposite; one may put too many on time deposits, and they would have to pay the opportunity cost of not owning a higher-yield investment.

In conclusion, these cognitive biases, confirmation bias, experiential bias, loss aversion, and familiarity bias, affected people’s investments. This can also be reflected in liquid or tradable securities as they fluctuate.

References:

Aguilar, O. (2021, November 3). Fundamental of behavioral finance: Confirmation bias. Charles SCHWAB Asset Management. https://www.schwabassetmanagement.com/content/confirmation-bias#:~:text=Confirmation%20bias%20may%20lead%20to,unfavorable%20news%20about%20that%20company.

Hayes, M. (2021, October 20). Guide to Investing Psychology. Investopedia. https://www.investopedia.com/terms/b/behavioralfinance.asp#:~:text=Behavioral%20finance%20is%20an%20area,the%20influence%20of%20psychological%20biases.

Kaplan Financial Education. (2021, July 23). What is Behavioral Finance?. Kaplan Financial Education. https://www.kaplanfinancial.com/resources/career-advancement/behavioral-finance#:~:text=Behavioral%20finance%20is%20the%20study,personal%20biases%20instead%20of%20facts.

Kase, M. (2018, November 24). The risk of familiarity bias in asset allocation. Schroders. https://www.schroders.com/en/au/advisers/insights/the-fix/the-risk-of-familiarity-bias-in-asset-allocation/

The Decision Lab. (n.d.). Why do we buy insurance? Loss-aversion, explained. The Decision Lab. https://thedecisionlab.com/biases/loss-aversion