Traditional finance assumes that investors always make perfectly rational decisions based on all available information. Behavioral finance, on the other hand, recognizes that as a result of our limited cognitive abilities (cognitive biases) or emotional tendencies (emotional biases) humans make mistakes.
We all have these biases and they are more powerful than we realize. They frame information for us so that it "feels" like we’re being rational, but in fact, they lead us to make decisions that are completely wrong. For example, an investor who sells at a low point in the market is acting irrationally. A rational and unbiased action would be to buy more because the market is on sale.i
Below is a list of six common investor biases, and explanations of how they can affect investment performance:ii
While we cannot completely eliminate irrational decisions caused by our natural biases, we can reduce the frequency of them by:
- Acknowledging that biases exist and trying to understand them better,
- Having accountability for our decisions. Board of Directors, Business Advisors, and Financial Advisors create “built-in” accountability and a sober 2nd opinion.
I couldn’t sum this subject any better than with one of my favorite quotes from Mark Twain.
“It ain’t what you don’t know that gets you into trouble.
It’s what you know for sure that just ain’t so.”
i http://www.investopedia.com/articles/investing/051613/behavioral-bias-cognitive-vs-emotional-bias-investing.asp
ii https://www.forbes.com/sites/peterlazaroff/2016/04/01/5-biases-that-hurt-investor-returns/#72ce9edd4ac9