Behavioral Finance

People often make financial decisions that work against their long term goals. The study of this is called behavioral finance and was pioneered by Daniel Kahneman and Amos Tversky. The investor needs to recognize irrational behaviors and seek to avoid them.

Some of the irrational behaviors are:

Overconfidence: People tend to believe they are better investors than they truly are and tend to attribute random events to skill.

Biased Judgments: Confirmation bias is the tendency to interpret new data in a way that confirms existing beliefs. People may interpret new data to confirm their existing investment decisions. Hindsight bias is the tendency of people to overestimate their ability to have predicted an event which they could not possibly have predicted. Outcome bias refers to the tendency to judge a decision by the outcome instead of the quality of the decision at the time it was made.

Herding: This refers to the tendency for most people to get into the market near market tops and get out of the market near market bottoms which is evidenced by the percentage of equity allocation in funds.

Loss Aversion: People feel the pain of a loss more than they feel the joy of a gain. This causes people to make incorrect decisions about when to take losses.

Pride and Regret: People have the tendency to want to swell with pride at their successes and avoid regret at their failures. We associate success with skill and don't want the responsibility for failure. In investing this leads people to be reluctant to realize losses and eager to realize gains leading to selling winners too quickly and holding on to losing investments too long.

 

Disclosure:

The information presented here is the opinion of the author and may quickly become outdated and is subject to change without notice. All material presented in this article are compiled from sources believed to be reliable, however accuracy cannot be guaranteed. No person should make an investment decision in reliance on the information presented here.

The information presented here is distributed for education purposes only and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or participate in any particular trading strategy.

Performance data showing past performance results is no guarantee of future returns.

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