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  • Writer's pictureTikona Capital

The psychology behind financial decisions: How our minds play tricks on our investments

Updated: Sep 25, 2023

In the world of finance, where rationality should seemingly prevail, the human mind often succumbs to its own psychological quirks, leading to perplexing decisions in investments. Delving into the fascinating realm of behavioral finance, this article uncovers the hidden mechanisms that influence our financial choices, exposing how cognitive biases and emotional instincts frequently play tricks on even the savviest investors, shaping the outcomes of their portfolios.




Synopsis


In this blog, we'll unravel the hidden psychology behind investing, exposing the quirks and biases that can turn even the most logical investors into emotional rollercoasters. So fasten your seatbelts and get ready for a thrilling ride through the world of behavioural biases!


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Welcome to the fascinating world of investing, where numbers, charts, and financial jargon reign supreme. But wait, there's more to investing than meets the eye! Behind the scenes, our own minds are engaged in a captivating dance of biases that can have a profound impact on our investment decisions.


In this blog, we'll unravel the hidden psychology behind investing, exposing the quirks and biases that can turn even the most logical investors into emotional rollercoasters. So fasten your seatbelts and get ready for a thrilling ride through the world of behavioural biases!


1. Confirmation Bias: The Silent Yes-Men of Investing


"Seeking out evidence that confirms our beliefs feels good, but it's not always in our best interest." - Daniel Crosby


Imagine having a team of loyal assistants whose sole job is to nod and agree with everything you say. Sounds great, right? Well, meet confirmation bias—the ultimate yes-men of investing.


They whisper in your ear, encouraging you to seek out information that confirms your existing beliefs while conveniently disregarding any conflicting evidence.


These biased buddies can lead you down a treacherous path, blinding you to warning signs and alternative perspectives. So, beware of these sly companions and open your mind to diverse opinions!


2. Overconfidence: The False Sense of Invincibility


"The market can remain irrational longer than you can remain solvent." - John Maynard Keynes


Picture yourself stepping into the investing arena wearing a superhero cap. That's the essence of overconfidence bias—it tricks you into believing you're invincible. Armed with this false sense of superiority, you may take excessive risks, neglect diversification, and ignore expert advice. But alas, investing is not a realm for caped crusaders. Be humble, acknowledge the limits of your knowledge, and approach investment decisions with a healthy dose of skepticism.


3. Herd Mentality: The Stampede of Irrationality


"Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas." - Paul Samuelson


Have you ever found yourself swept up in a crowd, following the herd without questioning why? In the investing world, this phenomenon is known as herd mentality. When the masses start flocking towards a particular investment, it can be tempting to join the stampede.

But beware, my friend, as this blind allegiance can lead to overvaluation during market frenzies and undervaluation during panic-induced sell-offs. Break free from the herd and think independently, lest you become just another sheep in the flock.


4. Loss Aversion: The Ghost of Past Losses


"The stock market is filled with individuals who know the price of everything, but the value of nothing." - Philip Fisher


Imagine a ghost that haunts your investment decisions, whispering reminders of past losses and making you tremble at the thought of future ones.


That ghost is none other than loss aversion bias. It amplifies the pain of losses, making you cling to sinking investments in hopes of recovering what's gone. Similarly, it tempts you to cash in on gains prematurely, afraid of losing what you've already earned.


Banish this ghost by embracing a rational approach that cuts losses when necessary and allows gains to run their course.


5. Anchoring Bias: When Numbers Hold You Hostage


"Stocks don't know you own them, and you shouldn't get emotionally attached to them." - Jack Bogle


Have you ever been held captive by a number, unable to see beyond its grasp? Anchoring bias loves to play this trick on investors. It anchors your decisions to a specific reference point, such as the purchase price of a stock, blinding you to changing circumstances and new information.


Break free from these numerical chains and evaluate investments based on their current merits, rather than being held hostage by past figures.


Impact of Behavioural Biases: The Plot Thickens


Now that we've uncovered the dark secrets of these behavioural biases, let's explore their impact on investment outcomes. These biases can lead to poor asset allocation, missed opportunities, premature exits, and increased market volatility.


Your portfolio might suffer from underperformance due to emotional decision-making and a failure to adapt to changing market conditions. But fear not, intrepid investor! There are ways to conquer these biases and emerge victorious.


Conquering Behavioural Biases: Becoming the Master of Your Investments


1. Stay Curious and Educated:


"An investment in knowledge pays the best interest." - Benjamin Franklin


Continually educate yourself about biases and their potential consequences. Stay curious, challenge your beliefs, and seek alternative perspectives.


2. Conduct Objective Analysis:


"The stock market is filled with individuals who know the price of everything, but the value of nothing." - Philip Fisher


Base your investment decisions on thorough analysis, considering both positive and negative aspects. Keep emotions at bay and let logic guide you


3. Embrace Diversification:


"Don't put all your eggs in one basket." - Proverb


Create a well-diversified portfolio that minimizes the impact of any single investment and reduces the influence of herd mentality.


4. Think Long-Term:


"The stock market is a device for transferring money from the impatient to the patient." - Warren Buffett


Focus on your long-term investment goals and resist the urge to react to short-term market fluctuations or noise.


5. Seek Wisdom in Numbers:


"In the business world, the rearview mirror is always clearer than the windshield." - Warren Buffett


Engage with other investors, professionals, or advisors to gain different viewpoints and challenge your biases. Surround yourself with diverse perspectives that can shed light on blind spots.


Conclusion:

Congratulations, dear reader, for joining us on this thrilling journey into the fascinating world of behavioral biases in investing. We've uncovered the devious tricks that our own minds play on us, turning investing into a psychological rollercoaster.

By understanding these biases and implementing strategies to overcome them, you can take control of your investment decisions and navigate the markets with more confidence and success. So, buckle up, embrace the challenge, and let your newfound knowledge guide you to investment triumph!

Sumit Poddar

Chief Investment Officer & Smallcase Portfolio Manager

Tikona Capital



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