Recap
In my last article I have talked a little bit about the origins of Behavioural Finance and I explained two of the major psychological biases. Let's just have a small recap:
- Behavioural Finance has emerged due to market anomalies
- It opposes the ideas of market efficiency
- It examines psychological biases that make for irrational investors
The last two biases we examined have been two very common ones: Anchoring and overconfidence. This time we will take a closer look at "loss aversion" and "herding".
Loss Aversion
Us human beings have a tendency to be loss averse. A common example to illustrate loss aversion is the case of the 100$ bill. For most of us, the regret of losing 100$ would by far exceed the happiness in case you found a 100$ bill. More precisely, several experiments have come to the conclusion that the weight of a loss is about double the weight of a gain. Behavioural finance suggests that investors are more sensitive to losses than to potential returns (and risk).
When do we typically come across this phenomenon in investing? I'm sure everyone who is invested in either the stock market or cryptocurrencies knows the feeling when their losing money. What are your thoughts in a period of losses? Many investors would be thinking something like: "Let's wait for the price to recover, this is just a phase". In some cases this may of course work and even be a good idea (of course this depends on the entry price as well). In most cases however, this behaviour keeps us holding on to losing investments. The regret about having picked a losing investment is too big and we want to at least come out even. On the other side, loss aversion also influences our behaviour towards winning investments. In this case, we tend to sell investments too quickly in order to realise a gain even when the fundamentals suggest an ongoing solid performance. So next time, you find yourself in one of these situations, remember that you are subject to loss aversion and reconsider your decision.
Herding
The second psychological bias I will cover this time is known as "herding". The definition of herding (google) is as follows: (With reference to a group of people or animals) Move in a group. In fact, we can observe herding in our everyday life. Just think of the latest new fashion trend, or the masses of so called "hipsters" that have seemed to come out of nowhere the last couple of years. We see something adopted by the majority and we feel that we are missing out on it. Another example are user reviews for products. I can't speak for everyone but at least I myself do rely on reviews when purchasing the next product from amazon.
Herding substantially contributes to the occurence of bubbles. Especially in the cryptospace where a lot of novice investors rely on other peoples "investment advice", coin prices can reach unnatural levels that are not justified by the fundamentals. Keep this in mind when planning your next investment.
Although herding is a common problem, you can avoid it by doing your own sound research about your next potential investment. Read whitepapers, think about the real potential of the investment and consider the competitors. Also feel confident not to walk with the trend. In fact you can also profit from herding. When the markets crash and everyone is selling off, this may be a chance to get some of the investments you had an eye on at a bargain.
If you liked this article, feel free to have a look at my prior article as well.
https://steemit.com/behavioural/@smoothlarry/behavioural-finance-for-cryptoinvestors-1
See you for the next episode ;)