Day to day activities are primarily driven by behavioral patterns. The same behavioral patterns also guide investing actions. Ever wondered why some investors/traders are able to time the market right almost every time, whereas others are always struggling just to break-even? Most likely, this is because successful investors have learned to overcome their behavioral biases. Knowledge about these biases can help an investor avoid and overcome the tricks the mind can play. (To learn more about how to avoid common biases read 4 Behavioral Biases And How To Avoid Them.)
Behavioral Biases can be divided into two primary categories: Cognitive Biases and Emotional Biases.
Cognitive Biases – These are a result of incomplete information or the inability to analyze and synthesize information correctly. Cognitive biases are generally easier to overcome through adequate education and training. A common form of cognitive bias is the Gambler's Fallacy.
- Gambler’s Fallacy – An individual who erroneously believes that a certain random event is less likely to happen following an event or a series of events. For example: Consider a series of 20 coin flips that have all landed with the "heads" side up. Under the gambler's fallacy, a person might predict that the next coin flip is more likely to land with the "tails" side up. This line of thinking represents an inaccurate understanding of probability because the likelihood of a fair coin turning up heads is always 50%. Each coin flip is an independent event, which means that any and all previous flips have no bearing on future flips.
Emotional Biases – These are a result of spontaneous reactions that affect how individuals see information. Emotional biases are deeply ingrained in the psychology of investors and are generally much harder to overcome. Some common types of emotional biases include:
- Endowment Bias – The tendency to overvalue an asset which an investor already holds. Put simply, investors tend to attach more value to the assets they own rather than the ones they don’t. This bias results in investors holding on to an asset for too long and possibly losing money in the process.
- Break-Even Effect – This suggests that investors who have lost money often jump at the chance to make up their losses. The urge to break-even can induce the loss making investor to take bets which they otherwise wouldn’t have taken.
The Bottom Line
Behavioral finance studies aim to complement traditional finance by spreading awareness among investors and portfolio managers of the power of biases. With adequate training and education, it is possible to shape investment behavior to overcome and avoid these biases.