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Economics is the social science which attempts to explain the behavior of investors and the market. But there is another school of thought called behavioral investing or behavioral finance. The key reason to concern yourself with behavioral investment theory is the following: In 2001 Dalbar, a financial-services research firm released a study, which concluded that average investors fail to achieve market-index returns. Behavioral finance experts explain the differences in return with a myriad of irrational investor behavior. A knowledge of behavioral finance will make you aware of the many ways sensible people make foolish investment decisions.

What is Behavioral Investing?

You may believe that you are a rational investor, however, research from the field of behavioral investment suggests that your emotions, your drive to emulate the actions of others, and your general aversion to loss influences your investment decisions more than the numbers on the page of an investment prospectus or financial report. Behavioral finance attempts to understand and explain how human emotions influence investors in their decision-making process. If you become aware of the pitfalls unearthed by behavioral investment theory, you can see to overcome those same pitfalls and make better investment decisions.

Loss Aversion

One of the most powerful behavioral finance concepts is that of loss aversion, which refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Studies have shown that individuals feel more pain from losing money than satisfaction from gaining the same amount of money. For example, if you were offered a sure $50 versus the chance to win either $100 or nothing ($0), most people would choose the guaranteed $50. This loss aversion theory helps us understand why many investors hold on to losing stocks. Have you ever held onto a stock even though the price was plummeting, hoping against hope that the price will come back? Gamblers on a losing streak will behave in a similar fashion, doubling up bets in a bid to recoup what’s already been lost. So, as you can see, despite our desire to avoid loss, we may actually be holding on to underperforming stocks and taking a huge hit. You can make your investment portfolio perform better by cutting your losses as soon as the price starts to plummet. On a wing and a prayer won’t make your stock price recover after the company has had a devastating quarter. When available information shows you no longer own a hot stock, force yourself to sell ASAP.

Confirmation Bias

One of the most common investing mistakes investors make is referred to by behavioral investment specialists as confirmation bias. Just like it sounds, confirmation bias means investors tend to look for and be persuaded by information, which confirms decisions or initial impressions. This means you are likely ignoring vital information, which could help the return of your investment portfolio. If you have ever purchased a stock, you know that research and analyzing information is a critical part of the investment process. If you fall prey to confirmation bias, you are seeking out information to point you in the direction you are already leaning towards. This means you don’t have an unbiased analysis of available information. The best decisions are made when we still consider conflicting info along with that which reinforces our initial opinion.

It’s clear to see how confirmation bias plays out in your portfolio every day. As investors, we are heavily and personally vested in our financial decisions. Naturally, we look for ways to ease our mind and support the purchases we made. To combat the pitfalls from confirmation bias, don’t be overly persuaded by information, which favors the decision you are leaning towards. Give this info the same weight as all other information. When it comes to analyzing market expert’s opinions recognize that even experts fall prey to confirmation bias. Carefully analyze this information and seek out a few other sources. If you can afford to, ask your investment advisor or another objective analyst to weigh all the pros and cons to help you make your decision. Make a pact with yourself not to ignore an objective analyst’s decision.

Overconfidence

Just as in any other facet of life, overconfidence can cause damage in your investment portfolio. In behavioral finance, overconfidence refers to people overestimating their own abilities. People think they are just as smart as the experts and often consider themselves excellent forecasters of the market. Overconfidence can result in excess trading or purchasing stocks which are just too risky. This creates a problem for investors because it causes more trading than is generally advisable. You should be concerned about this because excess trades can eat away at your returns especially if you are paying expensive fees. As with confirmation bias, the best thing you can do is read or listen to opinion that contradicts your beliefs. Another step you can take is to invest a small, test amount of your hard earned money first. Then, only invest further if the investment is actually showing positive returns.

People who can carefully analyze information and make unbiased decisions stand the greatest chance of finding reward in the stock market. Understanding how common human psychological conditions can get in your way of beating or achieving average market return will make you a better investor. There will always be a downside or potential for loss in investment. Keep your emotions in check and carefully analyze information to correctly play the market.