Behavioral Finance is a field of study that focuses on the psychological factors which influence investors’ decisions in financial markets based on how they interpret and act on specific information.
Regardless of how disciplined they are, people often make financial decisions influenced by behavioral biases. This makes investors act on emotion or make mistakes processing information, taking decisions that tend to be inefficient and irrational.
Biases affecting the market
The market is driven by the expectation of future price, while the expectation itself is a consequence of beliefs, knowledge, emotions, fear or greed.
Ignoring or failing to grasp this concept can have a detrimental influence on portfolio performance.
Behavioral Biases are separated into 2 categories: Cognitive and Emotional.
- Cognitive biases are caused by faulty cognitive reasoning.
More likely to be corrected through access to better information and education.
Most common Cognitive biases:
- Conservatism Biases
Traders maintain their prior views by overweighting initial beliefs and underreact to new information
Consequences: Maintaining positions for too long or being too slow to react.
- Representative Bias
Traders classify new information based on past experiences.
Consequences: May enter a trade based on a similarity and fail to do in-depth research
- Emotional Biases are influenced by feelings and emotions.
They are less likely to be corrected, but can be eliminated by recognizing, accepting and adjusting the behavior.
Most common Emotional biases:
a) Loss-Aversion Bias
Occurs when traders tend to strongly prefer avoiding losses than achieving gains
Consequences: Holding floating losses, to avoid locking in a minus or selling wins too early.
b) Overconfidence Bias
Investors place too much faith in their own abilities.
Consequences: Underestimating risks and overestimating expected returns. Excessive trading and failing to put in adequate stops.
c) Self-Control Bias
Occurs when the lack of self-discipline favors short-term satisfaction over long-term goals.
Consequences: Closing profits too early or closing small losses before a profit can happen.
d) Regret-Aversion Bias
Avoid making a decision out of the fear that the result will turn our poorly.
Consequences: Avoid trading and losing opportunities.
Do you see a bit of yourself in any of these biases?
While it’s difficult to remove biases from our lives, there are ways to minimize their impact by a robust, objective and disciplined process.
Get in touch with our Main Group FX agents and start building a strategy to help guide you back to rational thinking and improve your decision-making process.