MANILA, Philippines – There are three hidden biases that investors have to overcome to make sound decisions.
Larry Cao, a chartered financial analyst from Hong Kong, said understanding behavioral finance is key to being a successful investor because every decision to buy or sell is affected by biases that are lodged inside investors’ minds.
On ANC’s “On The Money,” Cao said one of these biases is mental accounting, wherein people think the value of P1 from one pocket is different from the P1 in the other pocket.
Cao cited as an example how some people do not equate the value of concert tickets to cash.
If a person lost a concert ticket worth P10,000, that person won’t buy another ticket worth P10,000 to make up for the loss.
However, if a person lost P10,000 cash, that person also won’t sell a P10,000 ticket to make up for the lost cash.
Cao also cited as an example the behavior of some credit card users who find it difficult to part with P10,000 cash but at ease in purchasing a P10,000 item through credit.
Another popular mistake is prospect theory and loss aversion, wherein people become irrational when it comes to making decisions about risk.
“Rational people, economists assume, will be able to analyze the odds of different events they get into. But in reality, people react to these odds in an irrational way,” Cao said.
He said this bias is often seen in casinos, which show that most people don’t like the possibility of losing money yet take chances despite unfavorable odds.
“Most people take their chances with money even when things don’t look right, they don’t realize when the odds are stacked against them,” he said.
He added that loss aversion is also seen in the stock market, wherein investors are not selling even when the trend goes against them.
“You are holding on to stocks not because you think that the company’s fundamentals are improving, but only because you cannot take a loss,” Cao said.
“That’s typical how a loss is drawn out from small to a loss that you can’t afford to take,” he added.
Another bias is heuristics and anchoring, which Cao said occurs when people jump to conclusions based on personal experiences and anchor decisions on a small piece of information rather than on the overall evidence.
One example of this is when investors buy stocks of a tech company based on the popularity of one if its products, without factoring in the whole performance of the company.
"Researchers checked out actual investors’ behavior at a particular brokerage and found that investors are twice likely to sell your holdings because you are so afraid to take a loss," said Cao.