Question

In the field of contemporary finance, we study the psychology and behaviours of investors. Discuss briefly SIX of the psychological pitfalls or behavioural biases that are common among the investors. Use one example related to investment to illustrate each of these biases.
(500 words)

Answer 1

The six behavioural biases that are common among investors are:

Loss aversion. Investors feel the pain of loss more than the joy of gains. For example, Investor remember losses forever, but they don’t remember the years they made 30 percent, only they remember is that they lost 20 percent.

Confirmation bias. Investors are often taken to information or ideas that validate existing beliefs and opinions. For example, an investor might have a belief about market conditions and are drawn toward information sources that confirm that belief.

Mental accounting. Mental accounting is there when an investor views various sources of money as being different from others. For example, when investors have employee stock purchase plans to buy company stock, they assume like they’re more loyal employees if they own it, even if it’s a bad investment and they’re not diversified.

Illusion of control bias. The illusion of control starts with the word ‘should,’ like, 'I should be able to pick the right stocks,' or 'someone should have the ability to time the market to achieve superior results consistently.

Recency bias. Investors sometimes believe what’s happened recently will continue to happen. For example, retail investors tend to chase investment performance, usually into an asset class just as it is peaking and about to reverse lower. Since the investment has been climbing higher recently, investors believe it will remain the case.

Herd mentality. Only because the larger herd is going into or out of a stock, sector or region, it doesn’t mean that’s the right move for an investor with his or her own objectives. For example, Investors who buy when the market is high and sell when the market is low are more than likely influenced by the herd mentality.