Behavioral Biases in Investing (Part 1/4)

Published on Feb 24, 2020.

Investors often find Markets & Stock prices are irrational i.e. Sometimes they are cheap and they remain cheap for a prolonged period of time, so sometimes they are expensive and keep getting expensive while all fundamentals say they should correct, but they don’t. There is no answer of this question in traditional finance books. But Why? Because traditional finance assumes that all Market Participants are Rationale. Doesn’t it seem a bizarre argument? Are we all not rationale while dealing with our Money .. ? Let’s see.

What do most of us do when we face a complex decision-making situation that demands sufficient time and efforts & have abundance information to process. Most of the time we do not systematically describe the problem, gather data or synthesize information to create rules for decision making rather we may follow a more subjective and sub optimal path of reasoning. That is, Individuals may strive to make good decisions by simplifying the choices available, using a subset of the information available and discarding some possible alternatives. The decision thus arrived is “Good Enough” and may not be the optimal decision as arrived by the scientific decision-making process. Doing so, individuals may bias the decision-making process which may result in irrational behavior and decisions. 

On the similar lines, Individuals may not behave rationally while making the investing decisions, a collective irrational behavior of Individuals make the market behave irrationally. Behavioral finance attempts to solve the unanswered puzzle of irrational market behavior and market anomalies. 

In this series of Investor Education, we are attempting to discuss the behavioral biases Individuals do exhibit while Investing. An understanding of such biases should lead to better decision making while investing. 

Broadly individuals are subject to these two types of behavioral biases – 

Cognitive – This category of biases come from faulty reasoning and can often be corrected by better information, education or advice.

Emotional – These biases stem from impulse or intuition and are not easily corrected. Because emotions come spontaneously and often cannot be controlled, it’s important to identify these biases and adapt the investment pattern as per these.

We will discuss in detail about the Cognitive and Emotional behavioral biases and the ways to modify them or adapt as per them in the next parts of this series.   

Team Clovek