Did you know behavioral biases play a role in your investments? The stock market swings between greed and fear. Finance is more about human psychology and behavior than numbers and ratios. You heard it right; humans react to stock markets with their own emotions, biases, and behavioral traits. We are sure you will be surprised to know that there is a separate arm of financial education specializing in behavioral finance.
Behavioral finance deals with the psychological influence on investors’ behavior and buying patterns. It emphasizes that investors are not always rational thinkers and have limited self-control. Their perspectives and biases influence them more often than not.
It studies how humans react to things differently if the slightest outcome changes. For example, if you go out to buy food and a sandwich, you pay cash and complete the transaction. Against this, if you don’t wish to go out, you may want to order food online and discover some discount offers. These food ordering apps often ask you to buy a bottle of coke for some additional cost but at a discounted price than what you would initially get.
You buy the other product because you get a small discount on the additional item. That’s what these marketing tricks do; they mess up your financial budgets. It may seem like a small example, but it also happens with the stock market.
Here are some behavioral biases and traits that you may resonate with
1) Confirmation Bias
Confirmation bias is when you would look for additional information on something you already believe in. For example, if you are bullish on a particular stock, you will look for information that will support your view. It is called a behavioral bias, where the investor will accept only that information that confirms their stock investment beliefs.
2) Loss Aversion
Have you been on a 10-day trip and had a bad experience traveling one day, so you engaged in road rage? Don’t forget, the remaining nine days and twenty-three hours were perfect. However, you will remember that you were deeply affected by that one lousy hour.
That’s loss aversion. Investors generally give higher weightage to their losses than their profits. So a loss of 10 percent on an investment will affect more than a 10 percent gain. Such loss aversion makes you dispose of the profitable bets much earlier and hang on to the loss-making trades.
3) Familiarity Bias
Familiarity bias involves investing in things you know or have heard someone talking about. For example, you like the product if you drink Starbucks coffee regularly. You may want to own a few company stocks. Such biases may lead you to invest in a closely held manner and may not allow you to diversify objectively. Objective diversification helps you reduce the overall portfolio risk.
4) Mental Accounting
It is one of the most relevant biases, as you would resonate with this bias in all stages of life. Mental accounting is when people treat money differently depending on its source of generation and use of funds. For example, if you find a 500 rupee note on the road, would you want to invest it, or would you like to spend it for a nice dinner?
Well, that defines your behavioral traits towards finance. Most would wish to spend the money on a nice dinner only because we got without much effort.
We segregate our money into “mental accounts” for different uses, which culminates in our spending habits. So, for example, we earmark some money cautiously when we mentally label it for house purchase but spend it liberally when it’s “fun money”.
5) Recency Bias
Recency bias, also known as experiential bias, makes a decision based on something that has happened in the past. For example, the health crisis in 2020 and the sharp recovery in the same year led investors to believe the stock market will always go up and is a quick-get-rich scheme. So, many new investors entered the stock market to make some quick money. However, the stock markets returned to mean reversion numbers and became very good only for investors with patience and time for the long term.
What Do Behavioral Finance Biases Tell You?
Behavioral finance lets you understand the impact of financial decisions on your investments, payments, risk, use of credit cards, and acceptance of new online investment options, cryptocurrencies, and personal debt. Your biases, human emotions, perceptions, and cognitive limitations of your mindset influence these decisions.