How can investors benefit from behavioural biases?

29th May 2012

We're all affected by biases in predictable ways – especially when it comes to investing. And the financial crisis has proved the point – As soon as headlines shout ‘double-dip recession' the stock market plunges and investors make a mad dash out of equities. 

When it comes to the heady subject of making and losing money, we're not as rational as we think – which is why there's a whole field of study that explains our sometimes predictable and strange behaviour.  

Here, Psyfi blog lists a wide range of the most common behavioural biases.

But Mindful Money asks – How can investors use knowledge of these to their advantage?

For decades, psychologists have been studying human decision-making and discovered that we are systematically irrational. But if we can become aware of our irrationality, perhaps we can use this to our advantage.

Take, for example, the familiarity bias.

This is the tendency to prefer stocks with which we're personally familiar. So, for example, we might choose to invest in Tesco because it's where we do our weekly shop and we feel we understand it. Or we may pick our favourite fashion brand as it's familiar and aligned with our interests and desires. 

As Psyfi blog says: "It's no good claiming that biases are both irrational and predictable if you can't then use that information to useful effect.

"Combining these research ideas gives us an initial suggestion that our external behaviours are biased by noise in the system and that the precise effects will be moderated by our genetic makeup. Neither should be surprising, as both genetic disposition and the laws of information processing are already well understood as limitations on behavior in other sphere of operation."

Another is fear of regret.

This deals with the emotional reaction people experience after realising they've made an error in judgment. Faced with the prospect of selling a stock, investors become emotionally affected by the price at which they purchased the stock. Put simply, we don't like to be wrong.

To take advantage of this bias, Psyfi blog says: "What investors should really ask themselves when contemplating selling a stock is, "What are the consequences of repeating the same purchase if this security were already liquidated and would I invest in it again?" If the answer is "no", it's time to sell; otherwise, the result is regret of buying a losing stock and the regret of not selling when it became clear that a poor investment decision was made – and a vicious cycle ensues where avoiding regret leads to more regret."

Behavioral finance certainly reflects some of the attitudes embedded in the investment system. It shows that investors often behave irrationally, producing inefficient markets.

And what about ‘confirmation bias'…

This is particularly apt in the current climate. It's the technical name for people's desire to find information that agrees with their existing view. And we all have an opinion on what's going to happen to Greece and the resulting market impact, don't we? So we'll hunt for news and information to back this up – even if subconsciously. But this doesn't help make us effective investors.

There are plenty of examples of this in all sorts of professions, from law courts to scientist's laboratories. So we shouldn't be surprised to find it coursing through the veins of economists and investors.

But how does this help us make informed investment decisions? It doesn't – so we should learn to be aware of this treat and tailor it to our advantage. 

Avoid being your own worst enemy

Trying to out-guess the market doesn't pay off over the long term. In fact, it often results in quirky, irrational behaviour, not to mention a dent in your wealth.

Essentially, putting together a strategy that is well thought out and sticking to it may help you avoid many of these common investing mistakes.

Behavioral finance offers no investment miracles, stresses Investopedia. However, perhaps it can help investors train themselves how to be watchful of their behaviour and, in turn, avoid mistakes that will decrease their personal wealth.


More on Mindful Money:

Why we buy cheap – and how investors can profit

Can the financial system be fixed? The Philosopher vs the Trader

Wellbeing, happiness and sustainability: hallmarks of a new economic paradigm

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