Behavioural Biases In Investment Decision Making: A Systematic Literature Review

The Fascinating World of Behavioral Biases

Introduction

Investing is a complex and intricate process that involves making decisions based on available information and forecasts. However, human beings are not always rational when it comes to making investment decisions. This is where behavioral biases come into play. Behavioral biases refer to the systematic errors in thinking that humans tend to make, leading to suboptimal decision-making. In this article, we will explore the fascinating world of behavioral biases in investment decision-making, based on a systematic literature review.

The Impact of Overconfidence Bias

One of the most prevalent biases in investment decision-making is overconfidence bias. Many investors tend to overestimate their abilities and believe that they have an edge over the market. This bias often leads to excessive trading, taking on unnecessary risks, and poor portfolio performance. Research has shown that overconfident investors tend to be less diversified and more prone to speculative investments.

The Role of Anchoring Bias

Another prominent bias in investment decision-making is anchoring bias. This bias occurs when investors rely too heavily on a specific piece of information or an initial reference point when making investment decisions. For example, investors may anchor their valuation of a stock based on its historical price, ignoring other relevant factors such as the company’s financial health or market conditions. This bias can lead to mispricing and missed investment opportunities.

The Influence of Herding Bias

Herding bias is a behavioral bias that occurs when individuals imitate the actions or decisions of a larger group. In the context of investment decision-making, herding bias can have significant implications. Investors may feel more comfortable following the crowd rather than making independent decisions. This can lead to market bubbles and crashes, as well as missed opportunities for contrarian investors.

The Pitfalls of Loss Aversion Bias

Loss aversion bias refers to the tendency of individuals to strongly prefer avoiding losses rather than acquiring gains. This bias can have a profound impact on investment decision-making, as investors may be more inclined to hold onto losing investments in the hope of recovering their losses, rather than cutting their losses and moving on. This bias can result in poor portfolio performance and missed opportunities.

The Dangers of Confirmation Bias

Confirmation bias is a cognitive bias that occurs when individuals seek out information that confirms their pre-existing beliefs or hypotheses, while ignoring or dismissing information that contradicts them. In investment decision-making, confirmation bias can lead to a narrow focus on information that supports a particular investment thesis, while disregarding warning signs or alternative viewpoints. This bias can result in missed risks and poor decision-making.

The Role of Availability Bias

Availability bias is a cognitive bias that occurs when individuals make judgments or decisions based on information that is readily available to them, rather than considering a wider range of information. In investment decision-making, availability bias can lead to an over-reliance on recent news or events, leading to short-term thinking and potential misjudgment of long-term investment prospects. This bias can result in missed opportunities and suboptimal portfolio performance.

The Influence of Regret Aversion Bias

Regret aversion bias refers to the tendency of individuals to avoid taking actions that may lead to regret. In investment decision-making, this bias can manifest in a reluctance to sell an investment that has performed well but has the potential for further gains. Investors may fear the regret of missing out on future profits if they sell too soon. This bias can lead to missed opportunities and suboptimal portfolio performance.

The Impact of Framing Bias

Framing bias occurs when individuals make different decisions based on how information is presented or framed. In investment decision-making, framing bias can influence investor behavior based on how investment options are described or portrayed. For example, investors may be more inclined to take on higher risks if an investment is framed as a potential gain, rather than a potential loss. This bias can lead to suboptimal decision-making and increased risk-taking.

The Role of Self-Attribution Bias

Self-attribution bias refers to the tendency of individuals to attribute successes to their own abilities or decisions, while attributing failures to external factors or bad luck. In investment decision-making, this bias can lead to overconfidence and a lack of accountability. Investors may take excessive risks and attribute any gains to their own skills, while blaming external factors for any losses. This bias can result in poor portfolio performance and a failure to learn from mistakes.

Conclusion

Behavioral biases play a significant role in investment decision-making, leading to suboptimal choices and poor portfolio performance. Understanding these biases can help investors become more aware of their own tendencies and make more informed decisions. By acknowledging and overcoming these biases, investors can improve their decision-making process and achieve better investment outcomes.