Applying concepts of Behavioral Finance is core to our approach in handling our super-bot led Digital transformation projects for large financial service companies.
Let’s understand the nuances of Behavioral Biases here …
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Humans beings are rational creatures. Every decision they make, including economic ones, there is a rationale involved. We are at the peak of our reasoning prowess, and can make logical decisions.
To be fair, that’s not really the case.
The rational choice theory, which contended that people tend to make rationally calculated choices, which maximized gains and minimized losses, has been debunked.
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With groundbreaking research in the field of behavioral economics, we come to know the ugly truth- humans are not are rational as they’d like to think they are. They make irrational decisions all the time.
You’re probably rolling your eyes, thinking, duh! I’ve never made a bad choice in my life! What’s this author on about?
Truth is, we all make irrational choices, and behavioral economics provides ample proof.
The concept of homo economicus, or the rational human being, was first challenged by leading psychologist and Nobel laureate Daniel Kahneman, and human judgment and decision-making expert Amos Tversky.
They were the pioneers of the risk aversion theory- which basically means that, if presented a choice between a guarantee of getting a 1000 bucks and 50% chance of getting 2500 bucks, humans will most likely go for the 1000 bucks.
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The choices we make often tend to be irrational because we are emotional beings, easily distracted by extraneous factors like social influence, and internal factors like feelings. There are various biases which creep in the decision making process, and make us take decisions which are not often in our self-interest.
This is especially important in the world of money and finance. Investors who put their money in mutual funds make unwise economic choices all the time. Here, again, there are certain biases which color the process of making these choices.
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What are these biases that investors in mutual funds suffer from? Let’s take a look.
Biases are of two types-cognitive and emotional.
Cognitive Bias: This is a systematic pattern of deviation from rationality in judgment.
There are certain types of cognitive bias.
Confirmation Bias: Cherry-picking data that only confirms what we think we know is confirmation bias. In this type of bias, we are drawn to information or ideas that only validate our existing notions about something, thereby giving us only half the picture.
Gambler’s fallacy: The mistaken belief that, if something happens more frequently than normal during some period, then it will happen less frequently in the future, or vice versa. Investors have this kind of belief all the time.
Status Quo Bias: Investors can, more often than not, be resistant to change. They will repeatedly invest in the same stocks and bonds, instead of mulling over new schemes to invest in. While sticking to tried-and-tested investment schemes or companies is a safe practice, it might limit your profit potential as well.
Negativity Bias: When investors put more store by bad news than they put by good.
Bandwagon Effect: Also known as the herd mentality. No matter how much we want to make independent decisions as investors, ultimately, a lot of us tend to be doing what most people are doing. This is a phenomenon called ‘herding’- which is the tendency of individuals to mimic the actions of a larger group. Investors who buy when the market is high, and sell when the market is down, are most likely influenced by the herd mentality.
Choice Paralysis: Having too many funds to choose from can actually hamper investors’ ability to pick the right fund, tailored to their financial goals and objectives.
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Emotional Bias: When you make decisions driven by emotions, rather than by logic and facts. It has also been defined as a distortion in cognition and decision making due to emotional factors.
Loss Aversion Bias: The simplest explanation of this is that we tend to focus more on losses than on gains. Because of this, they try to limit losses at the expense of gains. For example, when a stock value is so down, the person holding can’t think of selling, even though the money redeemed thereafter can be reinvested in a higher quality stock. Instead, they hold, because of not wanting to accept the loss, and hoping that stock prices will recover eventually.
Optimism and Overconfidence Bias: All too often, when our investments are doing well, we tend to get a little bit too comfortable. This may cause us to become reckless with our portfolio, as well as think of ourselves as invincible- investors who can’t make mistakes.
Mental Accounting: It means people viewing certain sources of money as different from other sources. In the investor context, it means getting emotionally attached to certain stocks if it belongs to their employer, or a company started by their relatives etc.
Illusion of Control: Investors have a penchant for thinking they can pick the right stocks, or control the outcome of investing decisions, or that someone who manages investments can time the markets to get optimal results.
Recency Bias: Often times, investors seem to think that recent events will continue forever. The sole basis of predicting the long term future is based on recent occurrences- which really contradicts the inherent unpredictability of the market.
Hindsight Bias: The tendency to fancy ourselves as a know-it-all, who would have made the right prediction, in retrospect or hindsight, is way too common, and way too annoying. And harmful as well- this often leads to wrong choices being made.
Blind Spot Bias: This pertains to our penchant for self-denial. All too often, investors tend to think that they cannot make the wrong decisions- that they cannot be biased. That biases are behavioral quirks that only happen to others.
How to avoid bias:
It’s natural to be biased- there is no way out of thinking like this, even when putting one’s hard earned money in the market. However, what investors and finance management companies can do is minimize biases, by working their way around them.
What investors can do:
Remember that what happened today will not necessarily happen tomorrow, or in the long term. And a little respect for the uncertainty of the market, and our own ability to correctly predict outcomes, would help.
Overcome choice paralysis by using tools like screeners, read fund literature in detail etc.
Don’t blindly follow the market. And as Warren Buffet says, sometimes do the opposite of what the market is doing- after proper research, not just on a whim. It may work out.
Read and understand all available data regarding the fund you want to invest in, and especially look for information which is incongruent with your already conceived notions and beliefs. Look for dissenting voices, just to be on an even keel
Thoroughly analyze funds before investing, regardless of levels of success.
Have a detailed discussion with your financial advisor about market expectations, and what you can do in case of an economic slump.
How behavioral finance can help you as a financial organization:
If you’re a financial advisor, or an organization which handles financial matters, listen up. Behavioral finance can help you help your customers too! Financial advisors can use behavioral tools to help investors make decisions. Yes, applying the principles of behavioral finance can not just enable your investors to minimize bias. Funds can use it to locate mispriced assets, make investment decisions by understanding investor psychology, and even help fund managers with managing the investment corpus.
From Team JubiAI.
We believe in applying the principles of behavioral finance in our super-bots to help financial organizations take their business several notches up. You can request a consultation here: https://www.jubi.ai/