KEY QUESTION BEING ADDRESSED BY THE AUTHOR
How does human behavior impact investing?
SYNTHESIS OF THE ARTICLE
The writer enumerates 12 human behaviors leading to biases regarding investing. The identified behaviors are further elaborated using numerical examples and analogies. The human behaviors identified comprise; overconfidence, illusion of knowledge, fear of regret, mental accounting, reference point, familiarity, considering the past, cognitive dissonance, house money effect, the snake bite effect and endowment effect. The author advocates for a discipled and reasonable approach. Further, knowing the biases beforehand aids mitigating against risk.
The main inferences in this article are;
- Taking cognizance of human behavior, and inherent biases can help investors mitigate risk and avoid investing pitfalls.
- Profit investing is an arduous task bound by rules, and runs counter to emotions.
A summary of the human behaviors is provided as follows; overconfidence is described as a bias that results from accidental success and is exacerbated by online trading. High returns in the Dotcom era led many investors to believe they had an innate ability in selection of investment options leading to overconfidence on their part and the failure to account for inherent risk in subsequent investment decisions. The advent of online trading gives investors the illusion of making their own decisions leading to excessive trading with a disregard for transaction costs and taxes. Overconfidence, thus leads to investors having untenable expectations.
The illusion of knowledge is depicted as a human behavior that directly leads to overconfidence. The Sources of illusion of knowledge are identified as investors awash with information from the internet, the academic world, analysts’ reports and tips from family and friends. This increase in information leads to different reactions from investors. Overconfidence and the illusion of knowledge are identified for making investors make decisions that would otherwise be described as irrational.
The fear of regret and seeking pride, and mental accounting are bundled as a thematic topic on human behavior that make individuals feel better about themselves. Investors seek stocks that will lead to a positive return; however, this is not always the case. In the event of a stock rise, investors may sell off their investments too early and on the flipside in the event of a stock decline, investors may be tempted to hold on to a stock for too long hoping for a turnaround. The main problem of such thinking is identified as the impact of taxes on the portfolio. A tax credit or capital gains tax may be applied on the portfolio. A numerical example is provided for an objective vie on portfolio analysis.
Mental accounting is identified as another human behavior associated with the fear of regret and seeking pride. It comprises the viewing of investments in a myopic way and losing sight of the big picture that is: the portfolio. The author advocates for discipled investing that follows a course of action and rules despite emotional distractions
Reference point, representativeness and familiarity is a thematic human behavior area. Reference points occur at high or low levels or at specific dates. The choice of reference points is highly subjective, an incorrect reference point may lead investors astray. This may lead to a disregard for fundamentals as prices shift relative to the reference point. Representativeness and familiarity are the brain’s way of summarizing a vast amount of data. This often leads to biases based on experience. Familiarity leads to decision making based on current knowledge. Reference point, representativeness and familiarity leads to decision making without all pertinent information.
The consideration for the past is a dependent of memories that can be a depository of emotions that certain events brought into individuals’ lives. Events maybe pleasurable of painful of may lead to feeling of pride and shame. Failure to recall past experiences, cognitive dissonance, correctly may lead to accumulation of excessive risk that maybe detrimental to investment decisions.
Finally, the author identifies the House Money Effect, the Snake Bite Effect and the Endowment Effect as problematic behaviors impact investment decisions. The House Money Effect leads investors to erroneously classify prior gains as separate from their initial investment and upon with they can accommodate excessive risk. On the contrary the initial investment and returns thereof are in fact theirs to invest prudently. The Snake Bite Effect is based on prior experiences by investors often leading to them being over cautious. In a bid to avoid similar feelings of loss, investors tend to be overly cautions which may limit their future earnings based on the past. The Endowment Effect deals with placing disproportionate value to certain investments due to the emotional attachment. Investors risk losing future earning due to holding onto assets for too long.
Human nature, behaviors and biases are enumerated and identified as having a negative effect on investment decisions. Profit investing is identified as often running contrary to human nature. The author concludes by giving the rational for the study of behavioral finance as prior understanding of human behavior and its deleterious effect and how to mitigate against such pitfalls.