Traditional finance theory depends on the concept of the Rational Economic Man
(REM), a perfect individual who knows how to make the best financial decisions
under uncertainty. However the typical investor can’t view himself in this way and
can’t rely on his initial decisions being fully rational for multiple reasons:
We don’t always have all the necessary information we need
Even if we had the necessary information how we interpret and process it may be flawed
We may have inner conflicts prioritizing short term with long term goals
When facing complex financial and investment decisions, we are often working
with limited information and our ability to make complex deductions is also
limited, in the face of this what we usually do is satisfice ( choose a satisfactory
choice rather than the best choice) and apply heuristics (simple efficient rules to
make a choice). As a result our investment choices can be sub-optimal and we may
miss out on important opportunities. But that’s only half of the problem, despite our mental limitations we also face more powerful emotional biases. Even if our intellect was prime At times, it is subservient to such human emotions as fear, love, hate, pleasure, and pain.
Many times the 2 things making decisions for us are dopamine and serotonin.
This doesn’t mean you shouldn’t trust yourself when it comes to your investments
and always leave it to the professionals in every case. You can do a lot yourself
but you have to understand yourself.
You have to acknowledge the limitations and biases you face and understand how they are affecting your financial decisions. If you do so then you can start taking action to address them.
In the coming posts I will be looking at the main cognitive and emotional biases investors face and their consequences on their investment/portfolios, how to identify them and finally mitigate them helping you become a more rational investor.
Thanks and I hope you are excited to read my other posts!