By: Dr. Sunday Adache; Managing Director/ Principal Officer, PKF corporate; Contact: admin.lesotho@pkf.com +266-22329799
Navigating the Pitfalls of Behavioral Financial mismanagement:
Behavioral finance focuses upon how an investor interprets and acts on information in taking various investment decisions. In addition, behavioral finance also places attention on investor’s behavior leading to various market anomalies.
Overcoming Emotional Biases in Investing
In the world of finance, rational decision-making is often assumed, but human behavior can lead to irrational actions that impact investment outcomes. Behavioral finance explores these psychological biases and their influence on financial decisions. In this article, we touch on the pitfalls of behavioral finance and strategies to overcome emotional biases in investing. This is towards empowering upcoming investors to make informed and rational investment choices that may result in achieving financial goals overtime.
Understanding Behavioral Biases
Behavioral biases stem from learning shortcuts and emotional responses that influence decision-making. Common biases include: loss aversion, overconfidence, and herding, anchoring, consensus bias and familiarity tendencies.
Loss Aversion: The tendency to prefer avoiding losses over acquiring equivalent gains. This is another form of fear of failure or risk averseness.
Overconfidence: Believing in one’s ability to predict future outcomes with greater accuracy than is actually possible or realistic. A form of presumption of possessing abilities that places one in a special class above the common human herd.
Herding: Following the actions of the crowd rather than independent analysis. This is quiet common in our day due to the tendencies of copying social media over generalized propositions. It is common to find partial information, without sound bases or some relevant factors in information given to the public. In the era of everyone having a right to his own opinion, many wrong views are freely dispensed to the gullible public. We all need to be beware of social media propelled misinformation. This resulting from ignorant conclusions of societal opinion leaders and self-acclaimed jack of all traders. This phenomenon is applicable to all fields of knowledge, not only in investment or financial management.
Anchoring: Relying too heavily on the first piece of information encountered when making decisions. There is need to search for more objective and authoritative information before accepting the final position on an issue.
Impact on Investment Decisions
These biases can lead investors to making suboptimal decisions, such as:
- Panic selling investments during market downturns due to fear of further losses (Loss aversion).
- Overestimating the potential returns of speculative investments, there are individuals known for reckless optimism on issues generally. (Overconfidence).
- Buying into market trends without considering underlying fundamentals factors adequately. Mental laziness to apply one’s mind to other relevant factors in reaching a conclusion (Herding).
- Holding onto investments despite changing market conditions, again this may emanate from mental laziness to research or consult. It is common to have personal emotional attachment to investments that have lost reality. This can be termed as being married or attached to an investment. (Anchoring).
Overcoming Behavioral Biases
Awareness is the first step in overcoming behavioral biases. We are on this column to assist investors mitigate these biases by:
Education: Understanding the principles of behavioral finance and recognizing common biases can help investors make more rational decisions.
Setting Objectives: Establishing clear investment goals and a well-defined investment plan can provide a framework for decision-making and reduce the influence of emotions.