7 Impact of Heuristics and Biases On Investment

Impact of Heuristics and Biases on investment
Investment decision is greatly affected by heuristic biases. Various changes of setting such as,
price volatility, variations of economic situation have a gross impact on investors thinking.
Individuals constantly feel the fear of losing money thus impulsively react to market changes.
They change their long-term investment goals to respond to every financial experts opinion and
begin to have doubts of their investments.
Investors are thought of as a rational lot that take carefully weighted economically feasible
decisions every single time. A rational investor can be defined as one that always updates his
beliefs in a timely and appropriate manner on receiving new information and makes choices that
are normatively acceptable. For a long time it was thought that traditional finance theory is
accurate because it states that investors think rationally and make deliberate decisions, based on
various estimations or using economic models. However after a number of investigations, it was
noticed that human decisions often depend on their nature, intuitions, and habits, cognitive or
emotional biases hidden deeply at the back of ones mind. The new discipline, behavioural
finance, begun to develop after gathering enough information that confirm particular human
behaviour which is contrary to traditional finance theory. Behavioural finance is the study of how
psychology affects financial decisions and financial markets. Since psychology explores human
judgment, behavior and welfare, it can also provide important facts about how human actions
differ from traditional economic assumptions.
Consequently, investment decision processes based on forecasts and the great knowledge of
market participants are becoming more unrealistic in these days global financial markets. Various
changes of setting have a gross impact on investors thinking. The irrational decision proliferate
in such situations which determine inefficient investments or uprising losses, which reduces the
ranks of people willing to invest. Consequently financial behavior is a science that analyzes
behaviour subtlety of market participants as well as revealing their irrational decision-making
motives. Behavioural finance helps to avoid the impact of financial behaviour for investment
returns and thereby attract more individuals willing to invest.
Behavioural Finance is becoming an integral part of decision-making process because it heavily
influences the investors returns thus performance. An understanding of how our emotions result
in irrational behavior is indispensable for any investor. Investors can educate themselves about
the various biases they are likely to exhibit and then take steps towards avoiding it thus
improving their effectiveness. Some common mistakes made by investors are selling too soon
while booking profits, holding too long while facing losses, buying overpriced stocks based on
market sentiments. The key for an investor to succeed is to get in touch with the emotional
indiscipline he has exhibited, and deal with it so that it is not repeated. It is only when you
combine sound intellect with emotional discipline that you get rational behavior.
Taking investment decisions is the most crucial challenge faced by investors. Some personal
factors such as age, education and income also contribute to an investors decision making. On
the technical side, investment decisions can be derived from models of finance such as the
Capital Asset Pricing Model (CAPM). Decisions should not be reached without considering
situational factors that take into account the environment and the market psychology. Effective
investment returns in the financial market requires an understanding of human nature and the
financial skills. Thus heuristic biases should be given importance in the process of decisionmaking.
Markets could frustrate the greatest number of market participants and usually they do so by
taking advantage of common behavioural biases such as anchoring. If the investors sticks to this
behavioural bias, then the securities market will be very rigid, characterized by irrational noninformed decisions and little portfolio diversification will be exercised. The upcoming firms will
also have difficulty in raising funds at the securities market since the investors does not have the
initial value on which to build estimates.

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