Biases in the investment world
We usually only talk about the cold, hard facts of investments such as performance, risk, growth and the economy – hardly ever about the soft or so-called emotional side. The official term for this is "behavioural finance" and refers to investors' emotions or actions and the psychology behind investors' decisions and action.
Often, an investor will make the right cognitive decisions but then make irrational decisions based on emotions. These emotions often run high when markets suffer a downturn or many fluctuations or much uncertainty experienced in the past year. Panic often sets in, followed by strange and ill-considered decisions. Such emotions not only affects existing investors but many prospective investors as well where emotions are often a stumbling block. Many people struggle to decide on something they do not fully understand. Sometimes the fear of the unknown is so great that they prefer to stay just where they are. Much research exists on this in the investment world, and a lot is written about what makes people make irrational decisions. Studies show that people who make irrational or wrong investment decisions usually do so repeatedly, much to the detriment of their portfolio.
In trying to understand some investment decisions, it is helpful to look at some of the decision processes investors might have. The most common is referred to as investment prejudices or biases, and there are, broadly speaking, two types:
- The first is cognitive biases and
- the second is emotional biases.
A cognitive bias is when one makes wrong inferences from certain situations or information that is made available. For example, you see someone in a police uniform, and you assume that the person is a policeman. You could be wrong. It could be a crook in police uniform. Some "cold" cognitive biases are for example ignoring important information, making a decision based on irrelevant details or relying too heavily on only specific information when making a decision.
On the other hand, emotional biases are where people make incorrect decisions based on how they feel instead of considering the facts. In the next number of editions I will take a closer look at some of the more prominent biases and how they may negatively affect your investment portfolio.
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