In investing, it is often challenging to make decisions very objectively. Here are 3 common behavioral economics phenomena that affect people, whether they realize it or not.
Pattern Seeking: Pattern seeking refers to the bias that we have when we seek out patterns that confirm our initial hypothesis. For example if you were to spot the rule in the following sequence “2,4,6” and initially gave the hypothesis numbers by go up by 2, you will confirm your hypothesis if you see another sequence 8,10,12. But maybe the rule could have just been “any 3 ascending numbers.”
Incomplete Memories/Recency Bias: This refers to the tendency for us to base our most recent events, or what the information that is most accessible to us the most a greater weighting when evaluating decisions. Our biological nature only allows us to remember the past in a limited capacity, as witnessed by our class not being able to recall our lunches the week before. In the example in lecture, investors also base their decisions more based on the emotional retrievability of an event. For example, many of the investors who suffered huge losses in the financial crisis were quick to remember these losses, even if on aggregate their returns were still positive. This is most likely due to the gradual positive earnings compared to the sudden negative drop.
Incomplete memories can mislead investors into making the wrong decisions if they put more weight into a more recent event that on aggregate should have a negligible effect on portfolio performance. For example if an investor a week ago bought a healthcare stock with a return of 25% and it dropped to 5%, and he or she refuses to buy healthcare stocks even though over the past year the average returns were 20% and above the relevant benchmark.
Anchoring: Anchoring refers to the concept of “attaching our thoughts to a reference point though it may have no logical relevance to an impending decision.” For example, in the case of investing, if a new company makes its IPO at 10 dollars and a competitor that went public a few months ago is now priced at 60 dollars, then our anchoring will be at 100 per share, and on average, investors will give higher estimates of the firm’s future value even if it is worth only $10 per share. Modern investment theory suggests that stocks should be based on values of projected earnings, yet many investors make the mistake of anchoring too high based on a comparison that may or not be relevant.