You might remember from the active versus passive investing article the efficient markets hypothesis, in which investors act rationally by incorporating all available information in determining whether to buy (or sell) a stock. But, are investors always rational? A quick look into history suggests that investors often act irrationally, making decisions grounded in emotion rather than logic and rational expectations.
One of the explanations for irrational decision-making stems from behavioral finance: behavioral biases cause individuals to act in ways which seem illogical. In this article, we will discuss some of the behavioral biases retail and professional investors are most likely to fall prey to when making investing decisions.
People tend to be drawn to evidence that confirm their existing beliefs. For example, if you have bought General Motors shares with the believe that it will perform well, you are more likely to find and retain new information that confirms your existing belief that the company will do well. The dangers of this are that investors are likely to discount news arguing the opposite – in this example, the investor may miss bad news that suggests the stock should be sold.
People tend to travel in groups – this is incredibly noticeable in the investing world. When a small group of investors begin buy (or sell) a stock, many more investors will follow suit, even if there is no rational justification why that stock should be bought (or sold). This mentality is exemplified during the creation and popping of stock bubbles. During times of uncertainty, investors will look to one another to determine how to react. As a result, the actions of one investor creates a domino effect which exacerbates the consequences of a market crash.
Most people hate to lose – even more than they love to win. In the context of investing, an investor will react more strongly to losses than profit. Take this example of loss aversion: an investor sees a stock with strong fundamentals do poorly for some time. Even though the stock was originally selected for the right reasons, the investor may lose track of the fundamentals and make a bad sell decision, selling a strong company at the bottom and losing out on the upside.
Mental accounting occurs when people to view money from various sources differently. For example, money from an inheritance is seen differently from money earned at a job – thus, people will choose to spend or invest money from these sources in different ways. These illogical distinctions cause investors to become overly attached to certain investments, clouding their view regarding whether the investment is a profitable decision.
These are just four of many different behavioral biases. Each of these biases are interconnected – when one manifests, it is likely other biases are also present. How to overcome these behavioral biases? The first step is becoming aware of what biases exist. From there, investors should establish unchanging trading rules so that they don’t act rashly. In addition, learn to research a variety of sources to get diverse opinions and focus on forming your own decisions when it comes to investing.
Siyu Wu is from Colorado and attends Princeton University, pursuing a degree in Economics and certificates in Finance and East Asian Studies. Siyu will graduate in 2018. She hopes to synthesize her interest in China and East Asia with her passion for finance to eventually work in a career related to international finance and Asian capital markets.