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Are you really a rational investor?

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!

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