A wrong financial decision is a pit every investor wants to avoid, but we fail to occasionally from time to time. How do we become rational investor that can make a sound decision with precision? Are there inhibitions to the attainment of this rational accuracy?
Unlike before, human feelings, motive, and fears are now considered as factors that define investors. The pattern of investment choices, choice of stocks and affinity to risky investment are a crucial pointer to investor’s response and behavior, and their makeup determines the decision they make to that leads to profit or financial loss.
Behavioral finance has to do with what an investor will tend to make from an investment opportunity and facts. A rational decision is the one made void of the following tendencies such as bias, overconfidence and excessive emotion and when left unchecked can lead to poor investment decisions.
Let take a look at how some tendencies make or mar a rational decision for investment
Emotion and reason play a significant role when investment decision is made, but their emotional output will depend on whether the investment was profitable or a loss. It is observed that the pain of loss is more felt than the pleasure of making gain from investment. When a person takes responsibility for the loss, guilt sets in and this, in turn, create fear for taking risk. The guilt felt have a varying repercussion depending on what kind of investment was made. Someone might take solace in the dividend paid for a stock after losing money buying same stock.
Bias is the tendency to take side with information that aligns with personal belief. Bias is obviously expressed when people selectively put together piece of information that supports their bias. This bias very well applies to an investor who interprets information from a biased position. Emotions and deep beliefs fuels bias in great proportion. Bias is expressed using ambiguous evidence to back existing position.
Assumption of Control
This is a form of bias that makes people overestimate and lay claim to control events. People make assertion by assuming they control outcomes they never have control over or ability to influence in any way. Gambling, for example, is pure chance but a gambler might take credit for the outcome.
Making smarter decisions
This is a form of impulse bias that is triggered by an external factor. A person, for example, can go into impulse move after overhearing another person in a conversation over the stock he is considering to buy but has not yet made a decision to do so. This casual conversation can trigger a decision that is not solidly made through fact available about the stock/company.
A rational investor should own the fact that they have their own prejudiced and preconceived outlook on facts. The investor needs to acknowledge his personal confirmation bias and not turn a blind eye to facts and evidence that may be opposing to his own view. A reasonable investor can call for opposing ideas for critical evaluation.