17 December 2021

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Behavioral finance and the five mistakes to avoid

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Psychologist Daniel Kahneman stated that the human mind works at two speeds:

The first (System 1) is fast, impulsive, impatient, and emotional;

The second (System 2) is slow, cautious, and rational.

Traditional economics has always considered only the second speed (idealizing man as a rational decision-maker capable of maximizing profits and minimizing costs, capable of processing an infinite number of information and immune to external influences) even if, over the years the Seventies, psychologists such as Kahneman have shown that in reality the first greatly conditions economic choices and that the second is much more fallacious than one thinks (man is often irrational in investment decisions: learning to recognize emotions and cognitive errors is the first step for the informed investor).

This is how Behavioral Finance was born, a mixture of economics, finance, and psychology that embraces the many facets of the human mind and helps to recognize situations in which emotions and cognitive errors can make the investor more irrational, leading him to make more informed and thoughtful decisions. (Markets are often rational and efficient, but not always, and the same goes for people and their investments). Here are the five most common mistakes Pictet Asset Management explains:

Too much fear: Fear, insecurity, and greed can affect our results and lead to financial immobility. The case of Italy is emblematic, as there are 1,700 billion euros of liquidity in current accounts due to the fear and uncertainty of investors during the pandemic;

Overconfidence: it is the excessive security of one's abilities and often leads us to consider ourselves better or more capable than others, even in investments;

Home bias is a concept linked to familiarity and consists of investing in domestic securities because you know them better. The problem, for us Italians, is that our market weighs 1.5% of the global one, and the main risk is that of poor diversification;

Loss aversion: a loss weighs two and a half times more than a gain of the same magnitude, and this leads us to be risk-averse when we are at a profit and more risk-prone when we are at a loss (to get back to even faster, we are willing to take more risk, an attitude that generally only makes things worse);

Influence: Our decisions are influenced. Decisions can be made influenced by past experiences or how different alternatives are presented to us. An example is the herd effect: if other people decide, I also feel more justified in going down the same path.