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Biases and Theories Biases and Theories

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Biases and Theories

People are inclined to often trade or invest with preconceived ideas, or behavioural biases, that can result in decisions based on emotion. This section details some of the biases and theories that an investor can be susceptible to. These can be very significant influences in the poor decisions we make.

In the sphere of behavioural finance, there are a number of biases and theories that come into play and can affect investor sentiment. The short videos below explore some of the main biases and theories, such as:

Prospect Theory

Prospect Theory deals with the irrational way we process information, valuing gains and losses differently (with losses having a more profound effect on our happiness than gains) and the subsequent decisions we take.

Conclusion:

Loss does hurt, but get some perspective. Enjoy the wins too!

Confirmation Bias

Confirmation Bias is our tendency to try and find information that supports an initial thought or perception we have. We tend not to go after information that may challenge the idea.

Conclusion:

Never be afraid to challenge yourself; better still get someone else to challenge you.

Overreaction

Overreaction is an emotional response to news about a security that is generally led either by greed or fear and pushes the price artificially high or low. Thus, the price does not reflect its fair value.

Conclusion:

Don’t overreact. Consider all information in a balanced manner and act accordingly.

Mental Accounting

Mental Accounting is when we assign our money into “pots” depending on where it came from and what we are going to spend it on, we may have a holiday pot or bonus money pot whilst having a large credit card debt.

Conclusion:

Money is money, no matter where it comes from or what you use it for; always assign it the same value.

Herd Behaviour

Herd Behaviour is the tendency for individuals to copy the actions of a larger group. Individually, however, most people would not necessarily make the same choice.

Conclusion:

There is comfort in a crowd, but ask yourself this, "What would Warren do?"

Gambler’s Fallacy

Gambler’s Fallacy is our misunderstanding that random past events can have an effect on future events. A single coin toss always has a 50/50 chance of landing on heads – even if there have been a series of 10 tails tossed just before.

Conclusion:

Don’t make decisions based on misunderstanding, look at the fundamentals and make an informed decision.

Overconfidence

Overconfidence is the tendency to have an exaggerated belief in our own abilities.

Conclusion:

85% of male drivers consider themselves to be above average. They can’t all be right – know your limits!

Anchoring

Anchoring is the tendency to become attached to a single piece of information that may not be accurate or relevant in trying to draw an appropriate conclusion.

When making decisions you should always look to find multiple inputs. Don’t just rely on one input because that single input could skew your judgement completely.

Conclusion:

Don’t fixate on a single piece of information. Re-evaluate decisions and positions, have the fundamentals changed?

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