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Rational Investor Vs Smart Investor

What is the definition of behavioural bias in finance?

Behavioral finance is a branch of finance that focuses on psychological factors that influence investors' financial market decisions based on how they interpret and act on specific information.

Behavioral finance researchers have discovered that we use a variety of mental shortcuts when making complex decisions. And these heuristics can cloud our judgement and cause us to make poor financial decisions. Unconscious beliefs that influence our decisions are referred to as behavioural biases. They can also have an impact on your finances.

Here are five common cognitive biases that can affect your relationship with money, as well as strategies for overcoming them.

1. Mental balancing:

What it is: Mental accounting is the practise of treating money differently depending on where it came from and what we believe it should be used for.

The idea is that we divide our money into "mental accounts" for various purposes, which influences our spending decisions. When we mentally categorise money for a house, we guard it with our lives, but we spend it freely when it's "fun money."

That is why most people are more likely to spend windfall gains on luxury items even though they would save the same amount if they had earned it. Earned money has been mentally assigned to an account, but a $100 found on the street has not.

Why is it a problem:

Mental accounting can have a negative impact on your business. Instead of paying off credit card debt, someone can decide to save money for college. They'd be stuck paying hefty interest on their credit card bills if they carried a balance each month because the money was already "accounted" for.

They could have used the money that would have gone to interest to rebuild their child's college fund, or perhaps invest it and develop long-term wealth, if they had opted to pay off their credit cards instead.

What you can do about it: Make a budget to help you make better financial decisions and know when to save and when to spend. Also, make a strategy for how you'll spend the money you've received as a windfall.

2. Aversion to loss:

What it is: Loss aversion is a preference for avoiding losses rather than pursuing benefits. People are more sensitive to losses than comparable gains when making decisions, according to a 2019 study published in Scientific Reports.

Loss aversion, according to Robert R. Johnson, professor of finance at Creighton University's Heider College of Business, can cost us money. "The most common financial blunder is taking too little risk rather than too much risk," he argues. Loss aversion explains why: losses are more painful than profits.

Why is it a problem:

Loss aversion encourages us to avoid taking tiny risks, even when they are likely to be worthwhile. It's why individuals choose to save rather than invest, despite the fact that inflation will destroy the value of their money - and many investments will pay off if held for a long time.

"Investing in a diversified portfolio of common stocks is the surest method to grow wealth over lengthy time periods," Johnson argues. "A long-term investor shouldn't invest in low-risk, low-reward securities like money market funds, yet many investors do because they are afraid of stock market volatility."

How to deal with it:

Don't rely on emotion to get you through it. Make a plan for investing and stick to it. Consider assets that normally perform well, such as an index fund that tracks the standard and poor's 500, to make a mental effort to take some risk.

3. Bias for overconfidence:

What it entails: The tendency to consider ourselves as better than we are is known as overconfidence bias. It's a typical occurrence in the investment world. Individual investors who are overconfident do not manage and control risk appropriately, according to a 2020 study published in the International Journal of Management.

Why is it a problem:

The overconfidence bias causes an investor to overestimate his or her abilities and knowledge, which can lead to impulsive or unwise decisions. Overconfidence in one's investment abilities, for example, can lead to the belief that one can properly time the market (even though markets are notoriously unpredictable).

How to deal with it:

If you're a novice investor, seek advice from a specialist and get a second opinion on your investment strategy. Also, rather than trying to time the markets, stick to passive investing. Active traders, after all, have a lower success rate than those who purchase and hold.

4. Bias anchoring:

What it is: Anchoring is a phenomena in which someone places too much weight on an initial piece of information while making future decisions. When it comes to investing, this can have an impact on how you decide whether to sell or acquire a security.

Why is it a problem:

Because many financial decisions entail numerous complex assessments, anchoring bias is a risk.

A person may, for example, hold on to a stock for longer than they should because they've "anchored" on the greater price than when they bought it. Their assessments of the stock's genuine value are skewed by the purchase price.

How to get around it:

Take your time and do your research before making a decision. Anchoring bias can be reduced by doing a thorough analysis of an asset's price. Finally, be receptive to new information, even if it contradicts what you've previously acquired.

5. Bias in herd behaviour:

What it is: Herd behaviour occurs when investors follow the lead of others rather than making their own financial judgments. If all of your friends are investing in penny stocks, for example, you might consider doing so as well, despite the risk.

People tend to follow the herd because it provides a sense of security. There's also the "fear of missing out": sitting on the sidelines while your coworkers make money investing in GameStop feels awkward.

Why is this a problem?

Herd behaviour has the potential to backfire. It has the ability to create large bubbles, such as the Dutch tulip market bubble, the Dot-Com bubble, and even the mid-2000s real estate bubble... and bubbles bust.

How to get around it:

Take a step back and examine your investments carefully: Investigate a company's fundamentals to discover if it appears to be a good investment. Also, be wary of hot stocks advertised on internet forums.

The monetary takeaway:

Economists prefer to believe that we make financial decisions based on maximising returns and optimising outcomes. However, we are influenced by a variety of elements, including emotions and cognitive biases, when making decisions.

This can lead to financial miscalculations. It is easier to avoid them if you are aware of them. And having a financial plan to guide you is a crucial next step in making wise investing choices.

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- Authored by Aman Chandrashekhar, Junior Executive Member of Shri Ram Consulting and Research Centre

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