A beginner’s guide to behavioural investing

Our mind is an incredibly complex machine capable of processing volumes of visual and audio information in seconds. It is this ability which allowed our ancestors to evade potential life threatening situations while on hunting expeditions. However, evolution has not only enabled us to make quick judgements and determine risks in rapid time but also, calculate, speculate and think critically. This dichotomy of thought is the premise of Daniel Kahneman’s book “Thinking fast and slow”, a powerful testament to diversity within human cognition, which reveals that we are all susceptible to cognitive dissonance and behavioural bias.

Kahneman, a renowned psychologist and Nobel laureate, categorises these two thought processes as ‘system 1’ and ‘system 2’. Where system 1 is the quick approach and system 2 is the slow methodical approach. As investors and indeed as rational beings, we need to be aware of these two competing thought systems in order to prevent system 1 from dominating our decision process. The three examples outlined below are common behavioural biases which may lead to disastrous investing;

  1. Confirmation bias

We are perhaps all guilty committing this bias at some point in our lives. This is simply where we have a preconceived notion or idea and try to find information that confirms it. We essentially seek out facts which support our preconceived idea instead of gathering and examining data first and then forming a rational decision based on the evidence.  Investors beware! If you believe a stock is going to appreciate in value, pause for a second and ask yourself what are you basing your decision on? Is it hope, gut instinct or do you simply like the cut of the companies jib? Take a step back and employ system 2 and try to be as objective as possible, take in all appropriate information and finally make an informed decision.

  1. Optimism

Optimists are fun people to hang around. They are the creators and innovators in our society. Google, Apple and other similar tech start-ups were all created by people with a positive outlook on life. A world full of pessimists would be dreary and nothing would get done out of a sense of futility. But why is optimism bad for investors? Well when it comes to investing we may tend to exaggerate our forecasting ability.  A couple of lucky stock picks and suddenly we consider ourselves experts. Soon we become so confident that we take more risk, use higher leverage and ignore the fundamentals. There will eventually come a day when you will pay a hefty price for your optimism, the merger you expected to take place fell through, profits dropped for the second year in a row despite your anticipated increase. So be mindful and treat any optimism with a degree of caution.

  1. Availability bias

Which form of transport is safer, cycling or flying? The answer is of course flying. Statistically speaking you are far more likely to die whilst cycling than flying, yet many people would much rather hop on a bike than board a plane. This is down to the availability bias. People tend to recall dramatic events such as plane crashes and terrorist bombings far easier than non dramatic events. This is partly due to disproportionate and biased media exposure. Therefore in many instances we overestimate the likelihood of rare events occurring and underestimate the likelihood of common events occurring. Keep this in mind when investing.

So next time you find yourself investing using system 1, STOP, put it in a straight jacket and beat it into submission using the slow and methodical system 2. It may not be as fast or as sexy but it is smarter and will save you from embarrassing losses.

Keep an eye out for more behavioural biases and investment faux pas.

Written by Brian O’Toole

Filed in: Blog, Featured Tags: , , , , , ,

You might like:

See EU: Thoughts on Brexit See EU: Thoughts on Brexit
Today’s myth: the almighty central bankers Today’s myth: the almighty central bankers
If you want to invest in oil, storage seem to be the only option while the oil glut persists If you want to invest in oil, storage seem to be the only option while the oil glut persists
Will new stimulus keep China afloat? Will new stimulus keep China afloat?

9 Responses to "A beginner’s guide to behavioural investing"

  1. moncler doudoune femme says:

    I loѵe what you guys are up too. This soгt of clever work
    and гeporting! Keep up the superb works guys I’ve inсluded you guys to my рeгsonal blogroll.

  2. nouvelle chaussure de foot says:

    Heyа i am for the ρrimary time herе. I came across this board and I
    find It trtulү helpful & it helped me out much. I hope to present something bahk and help others like yoս helped me.

  3. canada goose magasin says:

    This iѕ a topic that is close to my heart… Cheers! Where
    are your contact details though?

  4. sac hermes d occasion says:

    I am reallƴ impressed with your writing skills and also with the layout on your blog.
    Is this a paid theme or did youu modіfy it yourself?

    Either way keep up the nice qualitу writing, it’s rare to see a great
    blog like this oone these dɑys.

  5. Prix Canada Goose says:

    Greеtings! Verʏ helpful advicе iin this paгticսlar article!
    It is the little changes that ѡill make thе most significant changes.
    Tɦanks for sharing!

  6. chaussures De foot Nike mercurial says:

    Greеtings from Colorado! I’m bored at work so I
    decided to check out your site on my iphone durin lunch break.
    I loѵе the info you present here and ϲan’t wait to take a look when I get home.
    I’m amazed at how quick your blog loaded on my phone
    .. I’m not еven usibg WIFI, just 3G .. Anyhow, great blog!

  7. socialeum says:

    A round of applause for your article. Will read on…

  8. nike ninja says:

    Greetіngs! I’ve been follοwing your blog
    for a while noա аnd finally got the bгavery to go aheɑd and
    give you a shout out from Kingԝood Tеxas!

    Jսst wanted to tell you keep up thе exϲellent job!

Leave a Reply

Submit Comment
© 2021 How to trade for a living. All rights reserved. XHTML / CSS Valid.
Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions..