One Step Towards Rational Investing

Traditional finance theory makes the assumption that all individuals are rational and that they are capable of making rational investment decisions after taking into consideration all the available information. However, this is not entirely true. Due to behavioural biases investors don’t always make rational investment decisions. Behavioural finance challenges these traditional finance assumptions and explores how individuals and markets actually behave. Many individuals exhibit various behavioural biases that impact their ability to make optimal investment decisions. Some of these biases are discussed below.

Overconfidence Bias – individuals who suffer from this bias usually have a false and misleading assessment of their skills, intellect or talent. Such individuals believe that they have superior skills when it comes to making investment decisions when this actually might not be the case. Since they let their ego get in the way of their decisions, they often end up making sub-optimal investment decisions. 

Self-Attribution Bias – this is a self-serving bias that makes individuals believe that the good outcomes are because of their superior skills while the bad outcomes are blamed on luck. This is really a corollary of the overconfidence bias that makes individuals believe that they are more skilled than they actually are.

Hindsight Bias – this bias is basically a misconception that one always knew the outcome after the event has gone. The belief that you always know what was going to happen after the event has passed. For example: when an investment witnesses sharp return, even if a person has not invested in that particular stock they would say that they knew that the stock is going to go up.

Confirming evidence Bias – this bias can be fairly dangerous as it gives individuals the false confidence that they are always right. This is because they form an opinion and then look for evidence that confirms their opinion. These individuals tend to ignore or dismiss evidence that contests their pre-conceived notions or opinion. 

Anchoring Bias – this bias occurs when an individual gives an inordinately high weightage to pre-existing or the most recent information and tends to completely disregard information gleaned in the past.

Herd Mentality – this is a very common bias when people tend to blindly follow the herd. Instead of depending on their own analysis, they blindly follow what the majority of the people are doing.

Loss Aversion – when it comes to making investment decisions, the idea is to make as much gain as possible and as little loss as possible. However, the aversion to recognising losses is so high that many investors would prefer to hold on to loss-making investments in the hope that the investment will eventually turn into a profit rather than book those losses.

Knowing and understanding these biases is the first step towards making rational investment decisions.