Some interesting psychological biases that impair financial decision making
Recently, a lot more finance/economics researchers are discovering the necessity of studying behavioral tendencies due to its large influence on individuals' financial decision making processes. I explore only but a few that I find interesting and believe people are most susceptible to.
Hope to help you save a few bucks.
Herding. As far as I know herding is the most explored psychological bias in the financial sphere. It is the tendency of people to make decisions based on other people's decisions. There is nothing rational about herding due to the fact that even in the face of overwhelming evidence against a decision, people choose to follow the crowd. Buying a share of a company because everyone is buying, selling because you see that everyone else is selling, buying that particular brand of shoe because everyone else seems to own a pair (to include a non-financial asset related example), and so on, are examples of herding behavior. It has been said that people follow the crowd because misery loves company (they are comforted by failing with others rather than failing alone should they choose to go against the crowd) and because when people go with the crowd it is easy to diffuse blame. Irrespective of why people follow the crowd, herding is not good or bad in and of itself. The problem arises when the initial leaders are going in the wrong direction- if they have made the wrong decision- leading to mispricing of financial assets and huge financial loss. Herding is a culprit in the formation of bubbles in financial markets. Due to a phenomenon known as regression to the mean, bubbles will eventually burst and prices will return to fundamental value.
Sometimes speculators are aware that a bubble is forming but join in trading, further increasing asset price and causing other irrational or unsuspecting people to buy in. They would then sell when they think the bubble has reached its peak in order to beat to market.
If you do not think herding is a neat phenomenon, it must be that you don't get it.
Overconfidence. This is one of the biggest issues that plagues investors in financial markets. People always think they can do better than the market so the sell and buy more frequently than is advisable. Research shows that investors who trade aggressively actually perform worse than the market- they certainly do much worse than they would if they traded less. The problem is that people tend to ignore the transaction costs and taxes they incur with frequent trading. Research shows that the less trading you do, the better for your portfolio.
Sunk Cost Fallacy. Imagine that you bought the new $10,000 apple wristwatch and something goes wrong with it. Imagine that you have to pay about $1,000 to fix it. Sunk cost fallacy tells us that most people will tend to spend that $1,000 to fix the wristwatch whether or not they actually like and/or use their apple wristwatch. Why? Because people tend to throw good money after bad. In a bid to rescue the amount you have already spent on something - something you might not even like, want or use- you will spend more money to recover your loses so to speak. Sunk cost fallacy interestingly shows that people do not know when to cut their loses ironically due to loss aversion.
Probability and the hot hand fallacy. Hot hand is a common gambling term. It is the false belief that someone who has won a lot already will continue to win. To make this concept easy to understand imagine you flip a fair coin 5 times and it comes up heads five times, hot hand fallacy is the tendency to now reason as if the probability of heads is now greater than 0.5 and so expect the chance that heads comes up to be higher than the chance that tails comes up when in fact their probability are still 0.5 each. According to the rules of probability this is obviously absurd since the probability of heads or tails are independent of previous outcomes.
Overreaction hypothesis. Refers to the idea that the value of winning portfolios (according to research by De Bondt & Thaler) will start to fall in the medium term while the value of losing portfolios will rise in the medium term due to the fact that people had initially overreacted to news. In their study De Bondt and Thaler defined winning portfolios as portfolios that had positive returns consistently over a 36 month period (losing portfolios had made loses consistently over the same period). People tend to overreact to good & bad news that affect profitability causing return on a financial asset to be correlated over short periods. However, in the medium run this correlation disappears due to regression to the mean.