Question

What are the various behavioral biases that investors have while investing? What is the law of one price?

Answer 1

1. Confirmation bias : We pay more importance to the information that supports our belief.

e.g. You think that oil companies' shares will go up. You'll focus more on the news pointing exploration of new oil sources rather than exploration of alternative soirces of energy which will have negative impact on oil companies

2. Loss aversion bias: The feeling of avoiding losses being risk avert person.

e.g. you sell your shares as soon as they go down by 10%. They might have gained 20% next day

3. Disposition effect: Labeling the investments as good or bad. Just because one of the investment has given good return, you hold on to it for a very long duration and sell the rest

4. Hindsight bias : Relying too much on the historical data and predicting the future on the basis of the same

5. Familiarity bias: having a preference for some familiar investment.

e.g. You have some idea of oil and gas sector and thus you keep investing in oil companies only. However, diversification is always the best option

6. Self-attribution Bias : People find their knowledge and experience responsiple for their gains, while external factors are being held responsible for their losses. This results in overconfident and wrong decisions

7. Trend chasing bias : People invest in the options that are in trend (might even be due to advertising).

e.g. Bitcoin bubble : Many people who do not even know about the technology behind bitcoins, is investing in it, simply because others are doing it too

8. Worry : it is a part of human behavious but can lead an investor to make wrong decisions and lose money

Law of one price states that the price of commodity, security or asset is actually same if we keep in account the exchange rates as well. It is in place because otherwise, it will lead to arbitrage. Suppose a security X is available $10 in Europe and can be sold in US for $20. An investor can buy it in Europe and sell in US and can make indefinite amount of money.