Behavioral finance looks at how emotional and cognitive biases affect investors' judgments, which usually causes them to go away from rational thought and start making decisions based on their emotions. Behavioral finance shows that emotional factors and mental shortcuts influence investors' decisions by a lot, while classical finance believes that these investors always make logical decisions. This questions the efficient market theory's claim that stock prices represent all available information.
Three types can be seen through the following: overconfidence, herding, and loss aversion. Overconfidence is a common bias in which investors believe they know more about the market than they actually do. Since they don’t actually know everything they claim to, they trade too often, making them take on too much risk, and leads to ignoring important market signs which may indicate the fall of a stock. This practice can lead to poor outcomes due to increasing trading expenses and bad timing. Investors may take part in herding when they follow the crowd rather than doing their own study over the market. This may lead to very significant crashes in the market, where the prices fall dramatically, or bubbles, where prices rise too much. The idea to go with the majority as they are being seen as “correct” or the fear of missing out (FOMO) are driving this kind of behavior. Loss aversion was identified by Daniel Kahneman and Amos Tversky as the urge to avoid losses instead of focusing on profits. This is when investors may choose not to cut their losses but to keep hanging onto failed assets hoping that they would eventually turn around to a profit. Holding onto these falling investments increases the probability of future losses.
Investors should take efforts that increase awareness and informed decisions to help to reduce these biases. It is important to spread your investments over a lot of assets to reduce the impact of a single loss. Emotional decisions may be prevented and controlled by establishing clear, objective rules for buying and selling, such as stop-loss orders. It should also be the investor’s priority to constantly review portfolios to make sure they are following their long-term goals so that they can prevent them from being impacted by emotions or temporary market changes. Another option would be to get professional advice by a mentor which could help to disregard their personal biases while keeping a neutral attitude by looking for experienced financial advice. Overall, understanding and using behavioral finance principles can help investors make better informed, logical decisions and avoid common mistakes as well as dealing with psychological biases can lead to improved financial outcomes by correcting market failures which are caused by irrational behaviors.
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