From the course: Behavioral Finance Foundations

What are behavioral biases?

From the course: Behavioral Finance Foundations

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What are behavioral biases?

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- [Instructor] What is Behavioral Finance? Well, behavioral finance combines behavioral psychology with conventional economics and finance, and the goal here is really to explain why people make bad, irrational financial decisions. In fact, at a high level, there's a number of key reasons why people seem to make persistently bad economic and particularly investment decisions. The reality is that investing is not easy. There's 4,000 plus stocks out there in the U.S. alone, and tens of thousands of stocks around the world. Most people can't process 4,000 different stocks all at once and all the information that occurs on all those stocks. There's no way a human being could do that for just one market, the U.S., let alone for Canada, the UK, the rest of Europe or Asia, et cetera. So the point is that because we have a limited capacity to process all this news and information, we tend to rely on things like rules of thumb as opposed to case specific analysis. We group stocks into arbitrary buckets, and doing that then hides important facts about the stocks, and as a result we make bad investment decisions based on that. We also tend to overweight the story behind a stock, rather than the numbers. Blockchain is a great example of that, sort of like the dot-com bubble. A couple years ago you could have told people that you had blockchain for hotdogs. and they would have been going crazy. Now blockchain for hotdogs is nonsensical, right? It doesn't mean anything. Blockchain is a technology, hotdogs are not. But people tend to get very, very excited about themes in investing and then overweight that story rather than looking at the numbers. We also tend to underestimate important influences on us, things like sentiment around a stock, or news about a stock. We tend to underestimate how these behavioral influences impact our view of the company. If a stock has a negative story on the front page of The New York Times, that often doesn't have much of a negative impact on the business, but people overestimate its importance. And then finally, the reality is that most of us, particularly after we've been investing for a little bit, we tend to be overconfident in our judgment. We tend to think that we're master investors, when in reality, stock market is still very, very complicated. If you think you've mastered the stock market, most of the time you're in for a rude awakening. So unfortunately, we tend to be overconfident, and that causes us to make silly mistakes and errors. We want to keep these behavioral influences in mind, and try to keep them in check as we're making investment decisions. All of these issues hurt our ability to judge investments and make financial decisions. In this course, we'll talk about how to control for those.

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