What Leads to Decision-making Errors in Behavioral Finance?
Investors are normal human beings but are subject to decision-making errors due to biases.
Here we classify these errors for better understanding so that we can understand how we as investors or financial advisors can avoid them during our decision-making process.
- Emotions: It refers to making decisions based on our current emotional state. We as investors base our decisions as per the emotional state we are into and neglect our gut which takes our decision-making ability further away from rational facts.
- Social Influence: This is when based on the information or decisions of others we tend to bias our judgment about a particular decision. This is when others influence our decision-making abilities.
Example: When you as an investor purchase a stock based on reviews received from our elders or friends rather than making decisions based on analysis/ research of the company functioning and model. - Heuristic Simplification: This is nothing but an information-processing error. Here we as investors tend to make the mistake of believing that two or more events are closely related wherein the life they aren’t.
- Self-Deception: We all have self-deception when it comes to decision-making ability. We as investors always have a sense of feeling that we have more knowledge regarding the subject matter where the fact is we don’t. Sometimes the case is that the information we have is not sufficient to make the decision but due to this error we believe that our information is sufficient to make the decision
Biases in Behavioral Finance
It is of utmost importance that we as investors or financial practitioners make decisions based on rational facts and principles and avoid being biased towards a particular fact or emotion which clouds our decision making abilities and in turn pushes us towards wrong decision making. This is understood as behavioural biases in investing.
- Disposition Bias: This is the most common type of Bias where investors sell their winners and hang onto their losers. Investors' thinking is that they want to realize gains quickly. Here we as investors sell our investment when they are in profits but when the same stock is in loss we hold on to the stock intending to get back to even or the initial price.
“The problem in this bias is that we as investors only focus on the performance of the stock only on the basis initial price of the stock and disregard the fundamentals.”
- Confirmation Biases: In this bias, we as investors tend to rely on information readily available which confirms our pre-established beliefs in a stock or investment option.
We all come across situations where we heavily rely on information available on various media platforms or the internet and base our future decisions even if the information is flawed. The problem - Confirmation Bias.
- Experimental Bias: Experimental Bias refers to a scenario when investors' memory of recent events makes them biased or leads them to believe that the event is far more likely to occur again.
Example: During the economic crisis 2008, the markets crashed and lots of investors lost huge sums of money globally. This economic event led many of us to leave the stock market with an expectation that the stock market investment is very risky and also if I as an investor again invest in the market and the economy crashes again then I will lose all my money, whereas in reality the stock market after the crash, recovered well in the coming years with the considerable growth rate.
- Loss Aversion: Loss aversion is known as a bias in which the investor places more emphasis on the concern for losses rather than that of market gains. Here investors prefer not to lose 100 rupees rather than gaining 100 rupees on the other hand.
- Familiarity Bias: We all are familiar with this bias as we all deal with it on a day to day basis. Here we as investors only invest in what we know such as the local stocks and domestic companies and avoid investment in companies we are not well aware of or companies from other geographical areas. This is known as familiarity bias in investing.
Because of this, we are not able to diversify our risk as we only invest in a single investment type and not across multiple sectors or investment types.
Example: Indians usually invest huge sums of money in gold and silver even if the returns are considerably low also if we on the other hand diversify our investment across gold, mutual fund, stocks, bonds, debentures. We considerably lower our risk horizon as loss in one instrument of investment will be compensated by the gain in the other.
How to Overcome Behavioral Finance Issues
- Prepare and Plan: As investors, it is very important for all of us to invest by preparing and also to plan our investment not just in a single market instrument but diversify our investment across sectors. Also to base our investment decisions on rational thinking which is further dependent on reliable information and facts about company performance.
- Focus on the Process: There are two approaches to decision-making:
- Reflexive – Going with your gut, which is effortless, automatic and is our default option
- Reflective – Logical and methodical, but requires effort to engage in actively
Relying on reflexive decision-making makes us more prone to deceptive biases and emotional and social influences.
Establishing logical decision-making processes can help protect you from such errors. Get yourself focused on the process rather than the outcome. If you’re advising others, try to encourage the people you’re advising to think about the process rather than just the possible outcomes. Focusing on the process will lead to better decisions because the process helps you engage in reflective decision-making.
