Over the last few decades, some of the most important research in finance has been done not in the domain of economics but in psychology. Behavioral Finance has been getting increased attention lately and for good reason. If an investor is confronted with a challenging decision that requires significant time and cognitive resources, often they are unable to produce a rational strategy for developing an appropriate course of action. Many investors also have a potentially overwhelming amount of information to comprehend. To make complex decisions, people don't typically follow a methodical approach to describing the issue at hand, recording relevant data, and synthesizing this knowledge into rules. It is more common for individuals to take a more subjective approach when deciding on the best course of action for themselves.
The dictionary defines bias as a statistical sampling or testing error caused by systematically favoring some outcomes over others, a preference or inclination that inhibits impartial judgment, an inclination or prejudice in favor of a particular viewpoint, and a personal and sometimes unreasoned judgment. Behavioral biases and systemic errors in judgment are the same thing, with more than 50 biases being applied to individual investor behavior in recent studies by researchers.
Constantly re-evaluating the past rather than accepting the latest information is a form of conservative bias. Unexpectedly bad earnings news could cause an investor to question the accuracy of his or her investment strategy. Consensual investing can lead to investors failing to act on fresh information because of conservative bias. Investors tend to reject fresh information and stick to long-held assumptions, even when new evidence suggests otherwise.
Confirmation bias is a selective vision that favors ideas that reinforce our beliefs over those that challenge them. After buying a much-wanted item like a TV, it's common for someone to hunt for the identical TV at a store with greater costs to ensure that he or she made a smart purchase decision. This conduct is driven by our attempt to reconcile the post-decisional conflict between our decision and the potential of being mistaken.
Hindsight bias occurs when people believe that something might have been predicted even if it couldn't. The limitless number of possibilities that could have occurred, but did not, makes it harder for people to comprehend what actually happened. It's a common misconception that people are better at predicting the future than they are.
A decision maker's tendency to respond to distinct situations differently depending on the context in which a choice is presented is known as framing bias. How word problems are described, the presentation of data in tables and charts, and the illustration of figures are all examples of how this might occur.
Having a predisposition to remember and emphasize current events and observations over those that occurred in the near or distant past is known as a recency bias. Investors' exploitation of mutual fund and other fund performance records is one of the most prominent and damaging forms of recency bias. Investment decisions should not be based solely on the performance of managers during a short period, such as one, two, or three years.
Our biases can really impact our investment performance negatively, as well as other decisions we make that are totally unrelated to finance. That’s why it is so important to take your time when making big decisions. It’s also a good idea to assume that you will never have all the necessary information to make the right decision. In other words, stay humble.