“Steely nerves and patience, a ruthless and tactical game plan, lots of compromises, and the ability to shrug off feelings of utter despair…” That is how The Times magazine describes a successful investor: a superhuman fully in control of himself and his undesired emotions. Here we should ask the question: what about the biases? Can an investor still generate market-crushing returns even under the influence of innate biases?
Cognitive Financial Biases
Financial biases are generally divided into two categories: cognitive biases and emotional biases. Cognitive biases are mostly a result of bounded rationality. Even though
, it sounds counterintuitive, bounded rationality is a great example of how the brain manages its potential considering its needs. Under the effect of bounded rationality, an individual estimates and rationalizes to a required/satisfactory level for efficiency purposes. To give an example, you might be willing to pay 20€ for a meal, even if it gives you a utility worth 18€.
Other famous financial cognitive biases include mental accounting, belief perseverance, confirmation bias, and information processing. Though most of these biases are present in quite different areas of life, from marketing strategies to making friends, mental accounting appears solely as a financial bias. It refers to the propensity to allocate money for specific purposes. The most detrimental effect of this bias comes from assigning sophisticated products and regular ones into different clusters. Then, the individual assesses the value of money spent depending on the cluster it was used for. As an example, paying 200€ at a bougie restaurant might feel cheaper than paying 20€ at a normal pizza place. This kind of reasoning makes people more vulnerable to sunk cost fallacy and perceived-value-based marketing.
Emotional Financial Biases
Cognitive biases are common but tend to be the most docile ones, meaning that they can be tamed and defied. Once
, an individual starts getting aware of
“The Mania” phase’s main target group is the public. This group trades more instinctively, quite often under the impact of various biases. For instance, in the “Media Attention” and “Enthusiasm” steps, the market volume increases in size. It seems like everyone is buying, so you should to. This is a typical example of herd behavior: small investors mimic the crowd. In the stock market, herd behaviour is infamous for causing dramatic rallies and sell-offs. It is reasonable to agree that in 2008 the herd mentality behind fire-sales started a domino effect in the collapsing banking system. A similar pattern of herd behavior is also seen on the “Blow off Phase” on the graph, labeled as “Capitulation”.
Emotional gap bias is another active force on the stock market. The term refers to emotional decision-making based on extreme emotions or emotional strains such as anxiety, anger, fear, or excitement. On the chart “Greed”, “Delusion”, “Denial” and “Fear” phases are mostly associated with this bias. Though
, not explicitly visible on the chart, a common financial mistake emerges from self-attribution bias. It displays a tendency to make choices based on overconfidence in one’s own knowledge or skill. A clueless investor who insists on buying or selling while ignoring the reality is probably acting under the effect of the self-attribution bias. This bias could be attributed to “Bear Trap” and “Bull Trap” phases.
How To Be an Unbiased Finance Bro?
The first and relatively easier thing to do is being aware of cognitive biases. As mentioned before, cognitive biases can be improved and behaviors can be changed. The non-trivial part is regulating emotional biases. It might seem counterintuitive but an investor can take note of his feeling and compare them with the “Wall Street Cheat Sheet” below. For instance, if he is feeling like a genius, making crazy profits. This might be a good time to sell even if the primal instincts are suggesting the opposite. Another advice is trying to avoid herd behavior. If the reason behind a trade is mimicking others, you might want to consider this decision again.
Afterall, being a blunt finance bro takes a lot of tears, sweat and blood. But there is always something that we can learn from behavioral econ.