I’ve always wanted to write about why investors do the things they do. I want to reveal the most common instances where emotion and psychology influence our financial decisions.
If you are reading this, and an investor, you have likely used one of these concepts in making your investment decisions.
The concept is called behavioral finance.
It’s a relatively new field that tries to combine behavioral psychology theory and economics and finance to explain why people make irrational financial decisions. Was that definition technical enough?
Hopefully by the end of the series of articles, you’ll have a better understanding of the reasons and biases that cause us all to behave irrationally. My hope is you recognize the behavior and correct it when it’s critical.
So I’ll try to make this as simple as possible without getting too technical.
Concept 1. Anchoring
I see Anchoring all the time with investors. The concept of anchoring is the tendency to attach or anchor our thoughts to a reference point. In many cases there is no logical reliance to that reference point. Investors do this with irrelevant figures and statistics. It can be a very frustrating and expensive habit!
A great example of this is when a stock drops for several days from a recent high, an investor thinks this price drop provides a buying opportunity at a nice discount. The reference point is the recent high. Sometimes stocks do have a unfounded short-term drops, however many times it’s based on poor fundamentals. So by anchoring on the previous high, the investors mistakenly believes that the stock is undervalued but instead is deteriorating.
How to Avoid Anchoring
The only way to avoid making the Anchoring mistake is objective thought. Be careful what information and figures you use to evaluate a security’s potential. Look at it from many different perspectives, and get a second and third opinion.
The next articles will cover Confirmation and Hindsight Biases, The Gambler’s Fallacy and Herd Behavior just to name a few. Really good stuff, so stay tuned. If you want this series of articles delivered to you automatically, click here for a free subscription and have them in your email inbox every Friday morning!