How Behavioural Finance Influences your Investment Choices

Introduction

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As humans, we fundamentally have certain behavioural traits that influence our decision-making. In the world of investing, these aspects influence how you invest, monitor, and hold your assets. Behavioural finance, an interdisciplinary field, combines psychology and economics. It provides a depiction of how investors make decisions. It explains how cognitive biases and emotions can lead to irrational choices. This significantly impacts your investment choices. This blog explores the ways behavioural finance affects investment decision-making and the practical ways to overcome the associated challenges.

Behavioural finance: In-depth understanding​​​​​​​

Behavioural finance challenges the notion that investors always act rationally. Instead, it suggests that you can often get influenced by emotional and cognitive biases. They cause you to make decisions which may not align with your long-term financial goals. Traditional financial theories, like the Efficient Market Hypothesis (EMH), assume that markets to be efficient. Investors make decisions solely based on logic and the available information. However, behavioural finance argues against it.

Behavioural finance biases that affect investment decisions

A range of behavioural finance biases can influence how you make investment decisions. They can lead to irrational choices, like buying or selling assets at the wrong time. Find them explained as under:

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• Overconfidence/familiarity bias

Sometimes, due to experience or familiarity, you may develop overconfidence. This makes you believe you have superior knowledge or insight about the market trends. As a result, you may trade them more frequently than necessary. Research shows that doing so leads to investments underperforming due to higher transaction costs and poor timing.

• Loss aversion bias

Loss aversion refers to investors’ tendency to feel the pain of losses more acutely than the pleasure of equivalent gains. When this happens, a bias can develop that leads to holding onto underperforming investments longer than necessary. In this case, the psychological discomfort of locking in a loss becomes hard to accept.

• Herding bias

The herding bias occurs when investors follow a crowd. This leads to disregarding their analysis, opinion, and market fundamentals. Such behaviour is frequently seen during speculative bubbles with irrational optimism. Participating in such forums or communities leads to making ill decisions. It results in inflated asset prices.

• Recency bias

Recency bias happens when you give too much weight to recent events while making your investment decision. In the process, you may end up ignoring long-term trends and historical data. For example, after a market rally, you might overly invest in riskier assets with the assumption that the upward trend will continue indefinitely.

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• Confirmation bias

With confirmation bias, investors tend to seek out and favour information that validates their pre-existing beliefs. This is essentially choosing to see things that confirm what you already believe. Such selective attention can prevent you from seeing potential risks in your portfolios or missing out on better opportunities.

Tips to overcome cognitive errors of behavioural finance

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Listed below are several strategies to help you minimise the impact of cognitive errors caused by behavioural finance :

• Set clear goals

Establish clear, long-term financial objectives and resist from making decisions based on short-term market fluctuations. Sticking to a well-devised strategy like this helps you avoid impulsive reactions that are powered by your emotions.

• Diversify your portfolio

Diversification is a solid way to reduce risk. It involves segregating your investments across different asset classes and sectors. This prevents over-exposure to any single stock or market. As a result, you can mitigate the risks of emotional decisions based on performance.

• Build a disciplined investment plan.

Implement rules such as rebalancing your portfolio regularly or setting up stop-loss orders. Doing so enables you to remove emotions from the equation. A disciplined approach ensures that you make decisions based on strategy instead of bias.

• Limit media consumption

Market news and social media can promote recency bias. They also lead to misinformation, which can lead to rash decisions. Limiting your exposure to such noise helps you stay focused on long-term goals and prevents you from falling for short-term trends.

• Consult a financial advisor.

A financial advisor can offer you an objective perspective and help you stay grounded during volatile market periods. They can provide insights and strategies that minimise the influence of your cognitive and emotional biases.

Conclusion

The concept of behavioural finance offers crucial insights into how cognitive biases and emotions impact investment decision-making. Recognising these biases allows you to take proactive steps to mitigate their effects and improve financial outcomes. No matter the type of bias, understanding how they influence decisions can lead to correcting your approach to more rational and disciplined investment strategies that align with your risk aversion and financial goals. By following the tips discussed above, you can make informed and objective decisions and avoid common traps that impact your financial success.

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