Experts of this field say that for investors, understanding these Experts in behavioural finance say understanding cognitive biases is the first step to recognising and avoiding them.
Richard H Thaler won the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2017 for his contributions to behavioural economics.
While giving away the prize, the Royal Swedish Academy of Sciences said that Thaler's work had "built a bridge between the economic and psychological analyses of individual decision-making.”
In sum, the field of behavioural science delves into looking for empirical evidence of common emotional biases that individuals face while making any decision.
Thaler's research on behavioural economics -- along with those of other protagonists Daniel Kahneman (Nobel prize winner 2002), his co-author Amos Tversky and Jack Knetsch -- turned conventional economic wisdom, that humans always act rationally and in their own interest, upside down.
Experts of this field say that for investors, understanding these biases is the first step to recognising them, and, hopefully, avoiding them.
Here then are some important biases that affect people’s everyday choices in investing, as outlined by Thaler in the book Investment Titans – Investment Insights from the Minds That Move Wall Street
Endowment effect: In 1980, Thaler coined the term, “endowment effect”, to show the tendency of humans to value items more only because they own them.
In the case of investments, this holds true for stocks that people have already bought them and are continuing to hold at a particular price, even if their price may have fallen or they may have proven to be bad investments.
If, however, the investor did not have this stock in her portfolio, she would never purchase it at this price.
Loss aversion: The concept of endowment effect also ties in with loss aversion, which forms a key part of Thaler's Prospect Theory.
Research has shown that loss of a particular amount causes investors twice the pain compared to the pleasure they derive from a gain of the same amount.
This leads investors to take a particularly conservative view, especially when they should be selling a stock that deserves to be sold. A notional loss is better than a real loss.
Overconfidence: Research proves that most humans are overconfident and believe they are more skilled than they are. For instance, a research showed that 84 percent of everyone polled rated their driving skills as above-average -- a statistical impossibility.
Investors apply the same overconfidence while investing in stocks and end up making mistakes.
Anchoring: Investors take a particular liking to important numbers and base their decisions around it. For instance, if you have purchased a stock, which has started falling, you will decide to sell when it either breaks even or if it comes back up to a round figure.
Mental Accounting: Humans tend to compartmentalise information. For instance, if you have made a lot of gains easily on trading, you will treat the money made from those in a different manner compared to money you would have earned the hard way.
This will change your risk appetetite when dealing with the money gained during the easy trade, even though it shouldn't.Confirmation bias: Here, individuals seek information which affirms their pre-existing beliefs. Say, you have purchased a stock that you are bullish on, you will feel greater trust listening to an investment expert who shares your view than another one who doesn't.