Behavioral Finance | Investor Irrationality #Finance

according to the downbar studies the average investor consistently sees lower returns than the Markets or the general universe of stocks and Bonds while there are a

number of reasons for this under performance one of the most significant factors cited is investor psychology in other words we are often our own greatest enemy when it comes to Investments fine when things are expensive and selling at the worst possible time so what can we do to

curb the shortcomings of our own mentality well answer this question in more on today’s plain bagel the efficient market hypothesis is a theory that purports the stocks price reflects all available information of the company in other words since so many investors are trading different

Securities we can assume that the prevailing market price reflects the stocks true value meaning there’s no opportunity to trade stocks above or below their actual worth there are many studies that support one form of EMH or another but there’s a key assumption behind

the theory that’s often called them the question you see EMH assumes that investors are at an aggregate level rational agents who carefully analyze their holdings and make decisions accordingly this is something that not everyone believes in fact another range of financial theory suggests the

exact opposite this field of study known as behavioral Finance combines behavioral and cognitive psychology with economic theory and it alleges that investors are often

limited in their capacity to rationally manage their money this means that we are oftentimes unable to optimize how our money is invested which leads to a number of shortcomings aside from providing interesting insight into the #1a73e8; text-decoration: none;">Markets understanding basic behavioral Finance can help us deal with our own irrationality after all by recognizing our own limitations

we can better avoid making common mistakes and perhaps even circumvent emotional influences that often dictate our decisions so let’s start by reviewing how behavioral none;">Finance frames the decision-making process whereas traditional Finance purports that humans calculate probabilities of outcomes to maximize utility

behavioral Finance suggests that we make decisions based on bounded rationality whereby rather than fully optimizing our decision-making process we instead focus on coming to

sufficient or satisfactory conclusions in other words to make efficient use of our time we often consider and process information until we get to what’s required but not necessarily what’s best a great analogy is to think about the last time you went to a store and bought an item on

sale before making the purchase you probably could have checked to see if other stores had a better price for the same item or you could have checked the rest of the store for a better deal and hey maybe you did but more than likely there’s been a time when you extended the sale as is and

this isn’t necessarily a bad thing it just means that our brains are great at efficiency we can recognize patterns very easily and come to quick conclusions about certain problems issue however is that these mental shortcuts don’t really work to our benefit in

href="https://cashnews.co/finance" style="font-weight: bold; color: #1a73e8; text-decoration: none;">Finance instead they lead to inherent biases that influence our decision-making process sometimes to a detrimental result so let’s get a better grasp on these biases we see in

investing and how we can mitigate them at a high level these biases fall into two categories the first of which are cognitive biases cognitive biases are errors in how we process or recall information they result in faulty reasoning or analysis think of when you’ve answered a math problem but

you came to the wrong solution you don’t have any attachment to your answer but at some point you forgot a rule or a step that led you astray likewise we see these errors when processing investment decisions and they take one of two forms firstly there’s belief perseverance biases which

as the name suggests are errors we employ as a way of supporting the conclusion we’ve already made a popular one is confirmation bias whereby a person subconsciously gives some more waiting to evidence that supports their conclusion unless we need to evidence against it in investing this may

come in the form of using one research report to justify stock purchase when there are ten others with red flags about the company the second type of cognitive biases are information processing biases which impact how we digest information a great example is mental Accounting

whereby investors divide their wealth into different mental buckets based on their source or intended use even though money is fungible or equal regardless of where it comes from for example in gambling participants often separate their winnings from the money they came with and are often quick to

spend their earnings even though there’s no real difference between the two sets of money cognitive errors are bluch aliy easy to fix they can be addressed pretty directly and just being aware of the fact that you might be taking a mental shortcut could help reduce its influence over your

monetary decisions to better avoid making these errors make sure to employ systematic processes when gathering and processing information about invest and recent out your decisions before committing to them now unfortunately the second type of bias known as emotional bias is a bit harder to address

these biases originate from impulse and are related to help people feel rather than how people think and as it probably where emotions can be pretty debilitating to our rationality a common emotional bias which we’ve actually already discussed in a prior CashNews.co is loss aversion whereby

we feel stronger about losing money than we do about gaining similar amounts another one most of us are all too familiar with is the self-control bias it’s the classic spending problem faced by large chunks of the population we often have difficulty training off short term gratification for

long term gain most people know they need to save more for retirement and yet they can’t help themselves when it comes to buying arguably unnecessary things but possibly the most important bias to understand for investors is the regret aversion bites simply put people never want to regret a

decision they’ve made and as such they tend to conform with what others do this has been theorized to lead to what’s known in Finance as hurting where people buy

into Industries that others are buying and selling destroys where others are selling regardless of whether it is a good time to do so or not this leads to something called market momentum

for example as Markets go down investors worried about losing more money sell their holdings which leads to the text-decoration: none;">Markets falling even further causing a vicious cycle so because investors tend to follow the herd bad situations often become much worse while being aware of these biases helps the primary issue is that they are difficult to change because they’re driven by raw

emotion instead the best way to mitigate emotional biases is to adapt our decision making an approach so that we can avoid the influence our emotions have for spending problems try leaving the card at home or using physical cash to reduce the convenience of spending to help with saving set up

automatic deposits to an investment account that takes money from your paycheck before you have the opportunity to spend it when it comes to Investments probably the best thing you can do is reduce how often you watch a performance limit how frequently you check on the

href="https://cashnews.co/markets" style="font-weight: bold; color: #1a73e8; text-decoration: none;">Markets and if you think you’ll need help hire an advisor you can call when you’re feeling an urge to transact after all investment decisions should always be made from a rational

standpoint if you’re on the verge of tears watching your stock performance you’re probably not in the best headspace to manage financial affairs biases have a far-reaching influence over the investment industry aside from affecting us on a personal level they impact virtually every

component of the financial Markets company management may be blind to prevalent issues in their firm investment analysts can easily be influenced in how they cover a company and even other

market participants who had the aggregate influence market performance itself may fall victim to the whims of the human brain we can’t control the biases of others but we can identify when they are present and adjust our own approach to ensure we don’t succumb to the same influences by

keeping our cool and employing discipline tactics we can find ourselves facing investment opportunities when the rest of the market is losing their heads and with that said we’re out of time if you like this CashNews.co please hit the like button and if you like what we’re doing here

please subscribe if you have any feedback or topics you’d like us to cover in future CashNews.cos leave a comment down below for the plain bagel my name is Richard coffin thanks for joining me today