These mistakes, in turn, may lead to predictable patterns in asset prices that create opportunities for other investors to earn abnormally high profits without accepting abnormally high risk.
Here are some of the behavioural factors that might influence the actions of investors:
1. Overconfidence and Self-Attribution Bias
2. Loss Aversion
4. Narrow Framing
5. Belief Perseverance
6. Familiarity Bias
Using Behaviour Finance to Improve Investment Results
Studies have documented a number of behavioural factors that appear to influence investors' decisions and adversely affect their returns.
By following some simple guidelines, you can avoid making mistakes and improve your portfolio's performance.
A little common sense goes a long way in the financial markets!
1. Don't hesitate to sell a losing stock.
If you buy a stock at $20 and its price drops to $10, ask yourself whether you would buy that same stock if you came into the market today with $10 in cash.
If the answer is yes, then hang onto it.
If not, sell the stock and buy something else.
2. Don't chase performance.
The evidence suggests that there are no "hot hands" in investment management.
Don't buy last year's hottest mutual fund if it doesn't make sense for you.
Always keep your personal investment objectives and constraints in mind.
3. Be humble and open-minded.
Many investment professionals, some of whom are extremely well paid, are frequently wrong in their predictions.
Admit your mistakes and don't be afraid to take corrective action.
The fact is, reviewing your mistakes can be a very rewarding exercise - all investors make mistakes, but the smart ones learn from them.
Winning in the market is often about not losing, and one way to avoid loss is to learn from your mistakes.
4. Review the performance of your investments on a periodic basis.
Remember the old saying, "Out of sight, out of mind."
Don't be afraid to face the music and to make changes as your situation changes.
Nothing runs on "autopilot" forever - including investment portfolios.
5. Don't trade too much
Investment returns are uncertain, but transaction costs are guaranteed.
Considerable evidence indicates that investors who trade frequently perform poorly.
Implications of Behavioural Finance for Security Analysis
Behavioural finance can play an important role in investing.
The contribution of behavioural finance is
- to identify particular psychological factors that can lead investors to make systematic mistakes, and
- to determine whether those mistakes may contribute to predictable patterns in stock prices.
If that is the case, the mistakes of some investors may be the profit opportunities for others.
See the above 5 common sense rules on how to keep your own mistakes to a minimum.