A Guide to Understanding the Psychology of Investing
Traditional finance is built on the assumptions that investors are perfectly rational and that markets are perfectly efficient. Behavioral finance challenges these assumptions, arguing that investors are human and are subject to psychological biases that can lead to irrational decisions and market anomalies.
Behavioral biases are systematic patterns of deviation from rational judgment. They can be broadly divided into two categories.
These biases stem from faulty reasoning, memory errors, or an inability to process information correctly. Because they are errors in thinking, they can be easier to correct with education, better information, and logical analysis.
These biases arise from feelings, impulses, or intuition. They are about what an investor *feels* rather than what they *think*. Because they are rooted in emotion, they are much more difficult to correct and often must be adapted to rather than eliminated.
These errors occur when investors irrationally cling to their prior beliefs, even when new information is presented.
Reluctance to update a belief, even when presented with new information. Investors underreact to new data.
The tendency to seek out and interpret information that confirms one's existing beliefs, while ignoring contradictory evidence.
Classifying new information based on past experiences or stereotypes (e.g., "this tech stock is just like the last one that boomed").
The belief that one can control or influence outcomes when, in reality, they cannot. This often leads to excessive trading.
The tendency to see past events as having been predictable. This can lead to an unfair assessment of past performance.
These errors occur when the brain takes a mental shortcut to process information, leading to a flawed decision.
Relying too heavily on the first piece of information received (the "anchor") when making decisions.
Treating different sums of money differently based on where they came from or their intended use, leading to inefficient portfolio decisions.
Making a different decision based on how the same information is presented (or "framed"). People are often risk-averse when a choice is framed as a gain, but risk-seeking when it's framed as a loss.
Overestimating the probability of events that are recent, vivid, or easy to recall, while ignoring less memorable but more relevant statistical data.
The pain of a loss is felt more strongly than the pleasure of an equivalent gain. This leads to the "disposition effect": holding on to losing positions too long and selling winning positions too soon.
Overestimating one's own knowledge and ability. This can lead to under-diversification and underestimation of risks.
The tendency to consume today at the expense of saving for tomorrow (hyperbolic discounting), leading to insufficient savings for long-term goals.
A preference for keeping things as they are. An investor might fail to make necessary portfolio changes out of inertia.
Valuing an asset more highly simply because one owns it. This leads people to hold on to familiar or inherited assets, even if they are inappropriate for their portfolio.
Avoiding making a decision out of fear that the decision will be wrong in hindsight. This can lead to overly conservative portfolios or herding behavior.
These individual biases can aggregate to create predictable patterns and anomalies in financial markets.
The tendency for past winning stocks to continue winning can be explained by biases like availability (investors focus on recent performance) and hindsight bias.
Bubbles can be fueled by a combination of overconfidence, confirmation bias, and herding. Crashes are often exacerbated by loss aversion and regret aversion.
The historical outperformance of value stocks over growth stocks can be partly explained by investors' overconfidence in predicting high growth rates for growth stocks, leading to their overvaluation.
Understanding these behavioral biases is crucial for both individual investors seeking to improve their decision-making and professional portfolio managers aiming to identify market inefficiencies and better serve their clients.