In finance and investing, there is a prevalent assumption that every investor is rational.  

But investors are not machines, and when making decisions, they are severely susceptible to various kinds of behavioral biases which induce them to deviate from the most rational decision and make mistakes. Behavioral finance serves as a significant bridge between the realms of psychology and finance by helping us to understand three common biases impacting investors. By recognizing these biases,you can strive to avoid errors in both your daily lives and investment decisions!

Probability Weighting

The first cognitive bias is called probability weighting. Specifically, people tend to overestimate low probability events and underestimate high probability events. One of the most well-known examples of this is the “9/11 event” which happened in 2001, when a group of terrorists robbed the planes and crazily crushed the planes into several large buildings, resulting in the loss of nearly 3000 lives. In response, the US government swiftly deployed federal security screeners to inspect airline passengers. The Federal Air Marshal Service was expanded and the cockpit doors were also greatly reinforced.

While these actions aim to prevent future tragedies, we must ask ourselves, how frequently do events like 9/11 happen in history? Surprisingly, prior to 9/11, no such event had ever occurred.  However, 77% of motorists have been through at least one car accident in their lives and 42,939 people have died in car accidents in 2021. Despite the significantly higher number of car accidents, the government’s actions and resources used to reduce these events are relatively scarce compared to those intended to prevent another 9/11. This discrepancy illustrates how people tend to perceive unlikely but vivid events as more likely than they truly are.

If the example of “9/11” seems to be rare, there are millions of examples that can be seen in our daily lives. For instance, during investing, investors often engage in speculative investment, which is inherently risky since investors hope to rely on the fluctuations of stock price to make money, rather than considering the true value of the stock. Since most of the speculative stocks are from emerging markets and generally have small capital value, the action of speculating is more like gambling rather than prudent financial analysis, leading to a much lower probability of profiting compared to losing money. Nevertheless, investors frequently show overconfidence in their investing skills as they mistakenly believe they have more control over outcomes than they actually do. Eventually, when disillusionment strikes, they too often find themselves with shattered dreams and insurmountable debts.

 Anchoring

The second cognitive bias known as anchoring refers to the tendency for individuals to rely too heavily on the first piece of information they receive. In behavioral finance, anchoring can significantly impact investment decisions, often leading to suboptimal and destructive choices. For example, when purchasing a stock, investors frequently anchor the original stock price as a reference point, and evaluate the performance of the stock relative to that specific price, failing to adequately consider the change in economic landscape and the company’s profitability throughout the times. Consequently, investors may stubbornly hold on to a stock despite its declining price, leading to further losses over time.

Although anchoring may not seem to be a severe bias, it could lead to profound damage. For example, anchoring, along with greed and ignorance, led to the 2008 financial crisis in the US which wreaked havoc on countless properties and lives. During this period, housing mortgage securities were sold primarily to prime borrowers who were deemed less risky due to their substantial assets. However, driven by ambition for higher profits, many investors began selling security to subprime borrowers - who are much more risky than prime borrowers due to their lower wages, lack of financial assets and lower probability of paying back the mortgage, anchored to the belief that subprime mortgage default rate should be the same as the prime mortgage default rate. This assumption led investors to overestimate the correlation between prime default rate and subprime default rate. In addition, investors were also wrong in speculating that the house price would remain stable across the whole of America despite some geographical areas’ decline because there wasn’t any case happening in history before. However, during the financial crisis, the house price across whole of American unexpectedly dropped by 23.4% during October 2008.

Availability Heuristic

The third cognitive bias is availability heuristic, which occurs when people estimate the probability of an event based on how easily they can think of examples of that event. This mental shortcut simplifies our decision making process, as there is no need to engage in extensive rational analysis. However, this could also cause problems as we might  lose some important information and choose examples subconsciously based on the vividness of the example rather than the representativeness.

For example, in real life, this cognitive bias is obvious in both places like schools and companies - teachers and managers are inclined to give students or staff performance scores based on their recent performance, such as the past month, rather than their overall performance throughout the year because they remember the recent month better. However, the emphasis on recent events may not actually reflect individuals’ general performances.

Similarly, the famous bubble in the financial market known as “the dot com bubble” in the 1990s was partially fueled by this psychological bias. The dot com bubble refers to a period of rapid rise in equity value of technological stocks, which leads led to subsequent overvaluation and a crash in stock prices. During this period, investors assessed the probability of a tech boom and potential profitability of earning through buying technological stocks based on easily recalled examples - their friend who became a millionaire by buying the stocks, news on newspaper and TV reporting about the soaring stock prices of technology stocks, the rampant growth of the stock market. Without conducting a thorough analysis of the current market situation, many investors followed the trend, purchasing billions of shares of stocks in hopes of striking it rich.

As like-minded investors congregated to discuss technology stocks, their confidence in the future of their investments grew. This concept is called availability cascade, which refers to a self-reinforcing cycle of collected belief through repeated public exposure. Unfortunately, the dream didn’t come true - overvaluation led to the crash of technology stocks, resulting in substantial losses for many investors.

As the famous investor Naved Abadali states, “economic conditions may differ from period to period, but human psychology is embedded among us and will not change.” Despite the constant fluctuations in economic landscapes, human psychology remains an elementary factor that influences decision-making processes and market dynamics. To be a proficient investor, you should first invest in your knowledge about human behaviors before investing in real stocks, and this article serves as a crucial step, perhaps the first step, toward expending your mental horizons and gaining insights into your cognitive biases.