Executive Summary: Two significant behavioural biases while taking financial decisions are Overreaction and Overconfidence. Overreaction occurs primarily due to Availability Bias, when one tends to give importance to the latest news or information and reacts in an extreme manner. Overconfidence is displayed by many individuals who have tasted success in their financial actions, albeit due to luck or by accident. One should avoid such behaviours and always remember to base their financial decisions on research and reasoning rather than emotions.
First let’s talk about Overreaction. As the term suggests, when you hear something and react more than you normally should, it is known as overreaction. An example most often cited is relating to car or plane accidents. Imagine that you were in a car accident in the recent past or if you witnessed one, then you would tend to be extra cautious while driving in the immediate future. You may even avoid travelling by air if you heard of a recent horrific plane accident. Over time, this behaviour will change and you will get back to your original driving mode or will start travelling by air again. So what does this behaviour explain? It just means that you have overreacted to a recent incident and have changed your behaviour accordingly. Has the road suddenly become more dangerous or have accidents increased overnight? Not really. But just because of your overreaction, this has changed your behaviour.
A similar action happens in your financial behaviour as well. When investors hear something negative about a stock or mutual fund, there is excessive selling even though the news may not warrant such a price correction. Similarly, when there is good news about a company, investors forget all the negatives and overreact by buying the stock aggressively. Over time, the price may eventually get back to the long term average levels. When people tend to rely more on the most recent news or on information that easily comes to mind, it is termed as Availability Bias. Availability Bias then leads to Overreaction, which results in taking extreme decisions based on the available information.
This is no different when it comes to money matters, and overconfidence is almost always a sure shot recipe to disaster. Remember that there is an extremely thin line between confidence and overconfidence. Common examples cited are when investors get lucky with a few stock picks and assume that any stock they buy thereafter will do well. Another example is when you save a lot for your retirement and are overconfident that your retirement corpus is sufficient, but do not actually do the math to calculate its sufficiency. You may be spending a lot more than you should and therefore although think you are comfortable, you may not be so in reality.
So how do you avoid Overreaction and Overconfidence? It is obvious that these two behavioural characteristics have a lot to do with the nature of an individual and it may be difficult to change this. The first step to avoid Overreaction and Overconfidence is to actually recognize that you are subject to these qualities. You should avoid Availability Bias to avoid Overreaction. Remember that short term approaches to investments can do long term harm to your goals. Therefore take a view on the recent information only after doing thorough research. Similarly, when it comes to Overconfidence, recognize that your financial planner can give a better view on the subject as he has better access to market news. It is recommended to use reasoning and research to overcome emotions while making financial decisions.