When it comes to making investment decisions, optimum results would most likely be enjoyed if the individual investor always made rational decisions based on solid data. In practice, however, this is rarely the case. Human psychological errors coupled with emotional decision making may cause many investors to make decisions that are biased and often irrational.
This fact of life makes it of paramount importance for investors to understand, recognize and compensate for these mental errors known as financial biases. In my opinion, the ability to recognize your individual biases can be the best way to beat them . . . along with the help of hiring a professional to guide you along the way.
When we experience a life event to which a large amount of positive or negative emotion is attached, that event tends to hold great significance for us, and we tend to view similar situations with the same type of emotion, whether or not it is appropriate. This is known as the anchoring effect, and it can cause investors to behave irrationally.
An example of this would be an investor who buys a stock that rises precipitously in value. This is a positive event, and this positive emotion can remain attached to the stock even after it has lost almost all of its value. The investor holds on to it on an emotional basis, and suffers monetary loss as a result.
A major issue for many investors is the tendency to try to predict future results from past performances. As a result, they will purchase investment products that may have performed very well in the past, erroneously believing that they will always perform at the same level. In other situations, they may sell a stock that has fallen in value, assuming that this means that it will not recover.
Humans, in general, tend to form beliefs and then attempt to find ways to justify and rationalize those beliefs. Investors often fall prey to this confirmation bias in the course of their transactions.
They will usually try to find information that backs up their predetermined assumptions, and this kind of information can usually be readily found. I once knew someone who was convinced that the Iranian dollar was going to go up in value by 100x over night. He found several sources on the Internet proving his point but that day of instant wealth never transpired for him.
Social conformity is a very powerful force which drives people to try to fit in with the herd. This approach to investing can be easily succumbed to, and short-term gains can seem to justify the practice. This herd based approach is intrinsically erroneous. If in investor bases their decisions on the latest trend or rumor, they may fall prey to making random transactions that are based on nothing but herd behavior and innuendo. The dangers of this approach are obvious, and investors should always be careful to steer away from the herd and do their own independent research before making any financial decisions. You typically see this at the top, or at the bottom, of a market. The problem is that at the top everyone is saying to buy and at the bottom most are saying get out.
There are many more ways in which the investor can fall prey to their own biases, but the remedy for most of them is similar. Investors should develop an investment strategy based on sound investing principles, not emotion, and they should monitor their decision-making processes to be on guard against the ever-present dangers of personal financial biases. A good financial advisor can help you keep emotion out of an emotion-filled arena.
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