Behavioral finance is a field of finance that combines the cognitive psychological theory with conventional economics to examine investor behavior rather than relying on normative assumptions such as rationality, to find out why the investors do not always make a rational decision.
Some of the biases as observed by behavioral finance are:
a. Loss Aversion. There is a tendency in humans to prefer avoiding losses to acquiring gains. The main reason behind this is that losses are considered twice as powerful, then making profits, psychologically.
This can actually lead to ‘loss persistence’, mainly because, when security prices fall and the investor starts getting investment in a particular stock, they don’t generally prefer to close their position in a loss. So they generally hold on to the investments, as they are unwilling to take losses.
b. Herding. This is like the old saying, which says ‘following the herd’. The investors generally ignore their own analysis and rather make the decisions that reflect the direction of the market. This strategy may often be rational, but it may not be of much benefit if the overreactions of the market participants result in the securities being overvalued or undervalued. This bias also results in correlated strategies and clustered trading.
c. Information Cascade. This is a result of the transfer of information from those who are first to act upon it, and whose decisions influence others, to the others in the market. Such information cascades result in a lot of market participants acting based on it, and perhaps overreactions to the information.
d. Overconfidence. Most people overestimate their capability to value security and predict its future trends. This may often lead to mispricing.
e. Representativeness. The investors assume that good companies and good markets are also good investment options.
f. Conservatism. The investors are mostly unwilling to change their stance easily.
g. Narrow Framing. The investors do not view the events from a broader perspective, they view the events in isolation.
1.1. Implications of Investor’s Bias
a. If some investors exhibit some sort of bias, as long as the number is large enough, the markets remain efficient. Therefore, there is not much impact of such bias on the markets.
b. For the investors, the biases do impact them. To avoid the vulnerability to the same, they must know their position and develop rules to limit the impact of such biases, such as putting position limits, stop-losses, excessive gains, and loss timeouts, etc.