Behavioral Finance is a relatively new branch of investment theory that helps us understand some of the common mistakes that investors can make. Some investment professionals denigrate the study of behavioral finance, which examines how and why people make illogical investment and savings decisions. But a look a almost any individual’s portfolio – or, for that matter, the extremes of market highs and lows – should reveal the damage that emotions wreak. Advisers often report, for instance, that prospective clients come to them with a clutch of funds that were popular themes at the time they bought them. Or, you many invest mostly in Australian assets, falling prey to what behavioral finance calls “home bias”.

Behavioral finance seeks to explain such predicaments. Once enunciated, the solutions seem obvious and simple. Some common pitfalls are:

Loss Aversion

Research has shown that individuals feel the pain of loss twice as much as they feel the gain. This leads them to do irrational things, such as panic or stay on the sidelines when markets become bearish. A solution to loss aversion is to focus on the long term and avoid awareness of short volatility by looking at your portfolio less frequently. Recognise that volatility will always occur.

Attention Bias

Amid the constant bombardment of information and news, it is downright difficult for individuals to rationally filter data. So they simply invest in what catches their attention. You should have clearly defined parameters for assets to include in your portfolio. Picking uncorrelated assets is a key principle. Investments that don’t pass the test should be dropped. It’s about discipline.

Adaptive Attitudes

We develop the same attitudes as people we associate with. Journalists and analysts belong to social groups that they identify with, just like other professionals and extensive readers of each other's output. A solution to the problems caused by adaptive attitudes is to create an external control structure that supports a clearly defined investment process.

Why Don’t You Buy Straw Hats in Winter

Dopamine is a “pleasure” chemical our brains release to give us a high and dull the sense of risk. “Insula” is a chemical that makes us feel risk-averse and anxious. When we do something that becomes successful, our body releases dopamine, which makes us want to repeat the action. Unfortunately investment markets move in cycles. Markets get high and come down. The danger is that when the market is up, and you bought something, you get a rush, You want that feeling again. So you want to buy something that has gone up. That’s why it can be against our instinct to buy when markets are low.

Overtrading is a Case for Investing in Funds

This is because those who trade stocks are more likely to fall prey to over-confidence, which leads to overtrading, which in turn is linked to the worst investment results. Self-attribution bias occurs when people attribute successful outcomes to their own skill but blame unsuccessful outcomes on bad luck.

Useful Reference Sites

A good resource site and introduction to investment challenges can be found at http://www.behavioralfinance.net and at http://www.fooledbyrandomness.com/.