Set out the behavioural biases that investors commonly show
The idea
Behavioural finance catalogues the ways real investors depart from the rational agent the models assume. Overconfidence produces too much trading and too little diversification. Loss aversion makes a loss hurt more than an equivalent gain pleases, which is why losing positions are held and winning ones sold — the disposition effect. Anchoring fixes a judgement to an irrelevant number such as the purchase price. Herding substitutes other people's conviction for one's own analysis, and confirmation bias filters out the evidence that would have changed a view. Knowing the list does not remove the biases; what limits them is process — written rules, decided in advance, that do not require calm judgement in the moment.
A practice question
Loss aversion describes the tendency for a loss to feel:
- more painful than an equivalent gain feels good — correct
- less painful than an equivalent gain feels goodWhy not: Reverses the asymmetry. If losses stung less, investors would realise them readily rather than avoiding it.
- identical to an equivalent gainWhy not: Symmetry is what a rational utility function over wealth would imply, and it is precisely what the evidence contradicts.
The asymmetry is what makes investors hold losing positions rather than realise the loss.
A harder one
Overconfidence in investing most commonly shows up as:
- excessive cautionWhy not: Caution reflects doubt. Overconfidence produces the opposite: larger and more frequent bets.
- excessive trading and under-diversification — correct
- a refusal to take any riskWhy not: An extreme of caution, and the opposite of believing one's judgement is better than it is.
Both behaviours follow from overestimating the reliability of one's own view.
The hardest tier
The most effective practical defence against behavioural bias is:
- greater convictionWhy not: Conviction is the raw material of overconfidence and makes contrary evidence harder to accept.
- more frequent monitoringWhy not: More frequent observation means more frequent sightings of loss, which triggers the very bias it was meant to control.
- a written process decided in advance — correct
Rules set calmly do not require calm judgement at the moment they are needed, which is when it is least available.
In the app: 18 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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