It can be hard to figure out why we make certain investment choices because of the way our minds work with behavioral finance. Sometimes, our emotions can make us choose things that aren’t good for our money in the long run. But don’t fret! This blog post is your guide to becoming a better investor. We’ll explore the science of decision-making and give you some proven strategies to make smarter choices. When you finish reading, you’ll have the knowledge to be a successful investor. Let’s start this exciting journey!
The Context
The key to successful investing lies in making the right decisions, however, due to human nature, people tend to avoid doing so. This is because evaluating all the relevant information requires both mental and physical exertion, which can be draining.”
In our experience, it’s normal to feel self-doubt during the investment process. This can be a good sign, as it shows that you’re evaluating your options instead of blindly following others. However, some investors still make irrational decisions.
By studying investment psychology, investors can gain greater control, maturity, and insight into human biases – qualities that distinguish smart investors from those who make foolish choices.
The Paradox Of Choice
It is widely recognized that the optimal strategy for investing in stocks is to purchase them when they are priced low and sell them when they are overpriced. However, as per behavioral finance, the human mind presents limitations that often prevent investors from following this approach.
Fear can lead to avoiding buying at low prices, and greed can cause individuals to hold onto overpriced stocks. In India, there are numerous options for investors, including 300 registered stock brokers, 5,200 individual stocks, 2,500 mutual funds, numerous ETFs, and thousands of bonds.
With so many choices, it can be overwhelming to make sound investment decisions.
Despite the obviousness of the solution, an investor’s success ultimately comes down to the decisions they make throughout their investing journey. Let’s examine the events that occur during the process of making decisions.
The Decision Process
In the context of decision-making, there are two portions to the brain: the first is emotional (our subconscious part), which operates automatically and makes most decisions without our knowledge. For example, reacting to a falling object.
Another area of the brain that requires work to activate is the logical part, which is similar to how thinking is typically difficult while trying to solve a math problem. When making investment decisions, we often blend both rational and irrational elements. The rational approach involves a deliberate evaluation of options based on identifying a problem, gathering information, and considering the advantages and disadvantages of each option.
Organizing thoughts, isolation, examination, assessment, calculation, and stillness are necessary for this.
Gathering pertinent data, clarifying options, and using a step-by-step decision-making process always helps you make more deliberate, considered selections when investing. Irrational investment decisions on the contrary are usually influenced by our environment.
Several things could contribute to someone’s beliefs or opinions, such as news sources, social media, pretentious influencers, personal biases, family background, childhood, a friend’s acquaintance, or even a recommendation from a distant relative.
It is hence important for investors to be aware of these factors and work to overcome them to make rational investment decisions. To gain a deeper understanding of the psychological factors behind poor investment choices, let’s examine some key irrationalities that play a role.
Blind Trusting Actions
Blind trust in stock markets refers to investing in stocks without conducting proper research and due diligence. An example of this is blindly following the advice of friends or family members without considering one’s risk tolerance and financial goals.
To get rid of blind trust, it’s important to educate oneself about the stock market and investment principles. This includes understanding the risks involved, doing research on the companies one is considering investing in, and regularly monitoring the performance of one’s portfolio.
Endowment Effect
The endowment effect is a phenomenon in behavioral finance where people place a higher value on things simply because they own them. In the stock market, it can lead to an irrational reluctance to sell a stock, even if market conditions indicate that it would be wise to do so.
For example, an individual may hold onto a consistently underperforming stock, simply because they have become attached to it because they own it. To overcome the endowment effect in the stock market, individuals can try to adopt a more objective, data-driven approach to decision-making.
This would involve conducting thorough research on a stock and considering factors such as market trends, company performance, and analyst recommendations, rather than relying solely on personal attachment to the stock. Another approach is to mentally distance oneself from the stock and view it as a purely financial investment can help to overcome the endowment effect.
Confirmation Bias
Confirmation bias is a type of cognitive error that happens when new information that contradicts pre-existing beliefs is given priority over information that reinforces those beliefs.
Confirmation bias is often known as wishful thinking in an informal context.
According to the confirmation bias, investors are more likely to seek out information that confirms their initial beliefs about an investment than they are to hunt for evidence that challenges them. Because one-sided information frequently skews an investor’s frame of reference and leaves them with an incomplete understanding of the situation, this bias can frequently lead to poor decision-making.
Take into account, for instance, a trader who hears about a hot stock from an unreliable source and is enticed by the prospective profits. To “prove” the stock’s alleged potential, investors might decide to do some study on it. In the end, the investor discovers a variety of positive investment indicators (such as rising cash flow or a low debt/equity ratio) that confirm his initial beliefs while ignoring financially devastating negative indicators (such as the loss of important clients or shrinking markets).
Creeping Determinism
This phenomenon—known as “knowing it all along”— occurs when someone assumes (after the fact) that the beginning of a prior event was predictable and obvious when, in reality, the occurrence could not have been properly predicted.
It’s also known as hindsight bias.
Hindsight bias, according to psychologists, is caused by our intrinsic desire to create order in the world by coming up with explanations that lead us to think that events are predictable. Even while this sense of curiosity is beneficial in many situations (such as science), making the wrong connections between an event’s cause and the consequence could lead to faulty oversimplifications.
For instance, a lot of individuals now assert that there were extremely clear signals of the technology bubble in the late 1990s and early 2000s (or any other bubble in history, such as the tulip bubble in the 1630s or the South Sea bubble in 1711).
This is a textbook case of hindsight bias in action; if the bubble’s creation had been apparent at the time, it probably wouldn’t have gotten out of hand and eventually burst. Hindsight bias is a key factor leading to one of the most potentially risky mindsets that investors and other financial market participants display: Overconfidence.
Overconfidence in this context refers to investors’ unwarranted conviction that they have superior stock-picking skills.
Conclusion
Incorporating psychology into financial decisions is a valuable strategy that smart investors and professionals commonly embrace. By being aware of and controlling the impact of emotions, investors can make better decisions and enhance gains while reducing losses. Intelligence in investing involves more than just intellect, as demonstrated by Benjamin Graham in his renowned book “The Intelligent Investor.” He described it as a demonstration of character as much as intellect.
Understanding the limitations of one’s brain can lead to improved investing outcomes for individual investors striving for success in this academic field. Have you ever encountered any of the biases described in this article? Feel free to share in the comments below.
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