Understanding Behavioral Finance: How cognitive biases influence Investment decisions

If you are into investing, you would know that investing is a complex process as it requires you to create a balance between analytical thinking, market understanding, and emotional soundness. Traditional finance theories often assume that investors make reasonable decisions based on all available information they have at their disposal. 

However, today, we have a relatively new field called behavioral finance, which says that human emotions and cognitive biases play a significant role in shaping investors' investment decisions. In today's article, we will understand behavioral finance and how cognitive biases influence our investment decisions. 

What is Behavioral Finance?

Behavioral finance is a branch of finance that explores how emotional and psychological factors influence our decision-making processes. Also, it talks about how these factors impact financial markets. Behavioral finance seeks to understand why we make certain financial choices, even when those choices might seem irrational or counterproductive from a purely rational standpoint. 

It recognizes that human behavior is not always predictable or consistent and that our emotions and psychological biases can lead to market inefficiencies and anomalies. One of the key concepts within behavioral finance is cognitive biases. Next, we learn about it.

What is Cognitive bias?

Cognitive biases are systematic patterns of deviation from normal or rationality in judgment, often leading to perceptual distortion, inaccurate judgment, and illogical interpretation. When it comes to investing, these biases can significantly affect how you, as an investor, perceive, analyze, and act on financial information. Some common cognitive biases that impact investment decisions include:

Overconfidence Bias: It leads you to believe that you possess more information and insight than you actually do, leading you to make risky investment choices without proper research or analysis.

Loss Aversion: You tend to feel the pain of losses more strongly than the pleasure of gains, leading you to avoid taking necessary risks or selling lost investments too late.

Confirmation Bias: It occurs when you seek out information that confirms your pre-existing beliefs and ignore information that contradicts them. In investing, it can lead to disregarding warning signs or dismissing alternative viewpoints.

Herding Behavior: People often feel more comfortable following the crowd, assuming that others possess more information and insights. It leads to market bubbles or crashes as entire groups make similar, often irrational, investment choices.

Anchoring: It occurs when you rely too heavily on the first piece of information encountered when making decisions. Investors might anchor their expectations to past stock prices or economic conditions, affecting their assessment of current market conditions. Let us understand this one bias in detail.

Assume you are considering buying a stock of ABC Limited. You have been researching the stock's performance for a while now and trying to determine its fair value. As part of your research, you come across an analyst's report that suggests the stock is currently undervalued and has the potential to double in price over the next year.

However, you also notice that ABC Ltd's stock price has been declining steadily for the past few months. It is trading at Rs 1,000 per share. A few months back, the stock was trading at Rs 2,000.

Now, here's where the anchoring bias comes into play. Anchoring bias occurs when you rely too heavily on the first piece of information you encounter when making decisions. In this case, the initial price of Rs 2,000 per share serves as an anchor, influencing your perception of the stock's value.

Despite the recent decline, you might unconsciously use that higher anchor price as a reference point for evaluating the stock's current value. As a result, you might perceive the current price of Rs 1,000 per share as a great deal, even though the stock's fundamentals and market conditions have changed.

In this scenario, the cognitive bias is the anchoring bias, as it leads you to focus too much on the initial price anchor of Rs 2,000 per share. This bias can prevent you from fully considering the stock's current value based on its actual performance and prospects. 

Overcoming Cognitive Bias

We hope the above information has helped you understand cognitive bias. Once you understand it completely, it will help you make more informed decisions and reduce the impact of emotional and irrational behavior on your portfolios. Here are a few strategies you can employ:

• Education and awareness: Simply being aware of these biases can help you recognize when they might be influencing your decisions. Staying informed about the psychological aspects of investing can lead to more objective decision-making.
• Diversification: You need to spread your investments across different asset classes, as it will help you mitigate the impact of irrational decisions on a single investment.
• Setting clear goals: Having well-defined investment goals can help you stay focused on your long-term objectives rather than surrendering to short-term emotional impulses.
• Consulting Professionals: If investing is not your cup of team, better take financial advice. Financial advisors can provide an objective perspective, helping you navigate turbulent markets and avoid making rash decisions.
• Taking time: Taking a step back, conducting thorough research, and not surrendering to the pressure of immediate decisions can help counteract impulsive behavior. 

Conclusion

As mentioned above, behavioral finance is new and will evolve with time. The best part - those who learn it, it promises to offer them deeper insights into how investors make financial decisions and how these decisions impact market dynamics. It bridges the gap between the idealized rational investor of traditional finance and the complex, emotional beings like you that actually make investment choices.

We hope the above content was useful and you will incorporate an understanding of cognitive biases into your investment strategies. It can lead to more balanced, rational decisions, ultimately helping you navigate the unpredictable world of finance with greater success.