As homo sapiens, we are designed to survive. Instincts and behaviors which made us last this long as species are now on our way of succeeding in the stock market. Behavioral finance – a rather new field of economics – explores the intersection of finance and human behavior. Below are some of the key concepts of this field:
Loss Aversion: Simply said, the regret of losing 10% is more chilling than the joy of wining 20%. Our ancestors hated getting injured while hunting a gazelle much more than enjoying the pride of killing a giant mammoth. Coming back to the cave empty-handed was a much better option than coming back seriously injured. This thinking applies to investors today. In an attempt to avoid short-term losses in the stock market, most people overreact to daily news and abandon their long-term financial plans.
Overconfidence: If the cavemen weren’t overconfident in their hunting skills, they wouldn’t go out hunting massive beasts with their spears. They had to bring home the meat or they would starve. Investors are also overconfident assuming they know more than they do. They overestimate their investing skills. This overconfidence leads them to taking on too much risk. For example, hanging on to a stock hoping it will bounce back or having too much of one stock hoping it will continue to go up.
Confirmation Bias: We are pattern seeking creatures. Patterns help us predict and respond to natural events. For example, observing star formations in the sky when determining hunting seasons or observing the growth of certain plants to find the nearest river or lake. The more evidence we found confirming a given pattern, the more we bolstered that belief. When an observation didn’t coincide with that belief, we simply ignored it. Many investors still behave this way. If a piece of information doesn’t confirm their existing opinion about a given stock or asset class, they choose to ignore that information.
Stay tuned for part two and the conclusion of this topic…