Behavioral Finance: Why Investors Act Irrational and How to Avoid It

The stock market is about not only numbers, charts and analytical models. Considerably, it is also about the psychology of the participants. Even with access to the same information, investors can make opposite decisions. The reason is the different interpretation of events, emotions and behavior patterns that affect the perception of risk and profit.

This side of investing is studied by the discipline of 'Behavioral Finance'. Its genesis is at the intersection of economics and psychology, and it studies how irrational attitudes and mental distortions affect investment decisions. Unlike classical theory, where market participants behave rationally, the Behavioral Finance recognizes that in reality people are subject to emotional impulses and systematically make mistakes.

The term Behavioral Finance' was coined by psychologists Daniel Kahneman and Amos Tversky. In the 1970s and 80s, they studied how people act under uncertainty. Their seminal paper, Prospect Theory, laid the foundation for a new discipline that changed the way we think about financial markets. For this contribution, in 2002, Kahneman became the first psychologist in history to award the Nobel Prize in Economics.
Let's take a quick look at why people hold losing assets and ignore rational sell signals, and what you can do to avoid getting trapped in your own thinking.

Cognitive Biases: Key Causes of Irrational Behavior

Behavioral finance identifies dozens of biases, but in practice, investors most often encounter four:

1.    Anchoring

Essence: A person becomes attached to the initial purchase price of an asset and perceives it as the ‘norm’. Even if market conditions have changed, the person continues to focus on this figure.

Example: An investor bought PayPal stocks at $280 in 2021 amid the growth of digital payments. Two years later, the stock fell to $60. Despite the change in fundamental indicators (pressure from competitors, slowing growth, change in strategy), the investor refuses to sell. The investor believes that the ‘real’ price is $280, and the market will definitely return there.

What is the danger: When making decisions, the investor begins to rely not on the analysis of the current situation, but on a ‘psychological anchor’. Such anchor may be not only the price, but also some initial information that the investor learned about the company and included in the investor's "profitable investment" scenario. As a result, the investor ignores any other contradictory factors, even if they are more significant and reasonable.

2.    Sunk Cost Fallacy

Essence: Invested funds or efforts begin to be perceived as an ‘obligation’ – it is difficult for a person to close a losing position because he/she has already ‘lost a lot’.

Example: An investor invested $10,000 in a promising biotech company at the start; spent time searching for this idea, studied everything, and concluded that it was worth investing in. Then the investor took own savings and invested. As a result, the company unexpectedly failed clinical trials, and the stocks fell by 80%. However, the investor continues to hold them. Now the investor convinces himself: ‘I don’t want to fix the loss, the company is good, I studied it for many hours and invested all the money. Most likely, the stocks will still grow.’ In practice: the chances of recovery are minimal, but the desire to ‘win back’ overrides rationality.

What is the danger: An investor becomes a passive observer, unable to admit a mistake and redistribute capital into more promising assets in time.

3.    Herd Behavior

Essence: People tend to copy the actions of others, especially in conditions of uncertainty. This creates bubbles or mass panic.

Examples:

•    Mass purchases of meme stocks (GameStop, AMC) in 2021, caused by activity on Reddit forums. Many investors entered "on the hype", without analyzing the business model, and bought pre-bankruptcy companies at the peak. Consequences - losses of up to 80-90%.

•    The opposite situation - during the banking crisis in March 2023, many people sold bank stocks en masse, including fundamentally sound ones, due to general fear. As a result, most banks recovered soon, but those who sold in panic recorded losses. 

What is the danger: Herd thinking disables individual analysis, increases volatility and leads to ill-considered trades.

4. Confirmation Bias

Essence: A person tends to look for and pay attention only to the information that confirms an already formed opinion, and to ignore data that contradicts it.

Example: An investor who is confident in the company's prospects will read only positive analytical reviews and news, ignoring the objective problems of the business: decrease in revenue, key client attrition or negative judicial practice. Even if the facts indicate a deterioration, the investor will find a way to rationalize them.

What is the danger: Such bias limits the objectivity of thinking and reduces the ability to adapt to new information. The investor risks staying in a losing trade longer than necessary and missing the opportunity to adjust the strategy.

Why Else Do Investors Hold Losing Positions?

The reluctance to sell a ‘losing’ stock is most often caused not by logic, but by emotions. Let’s take a closer look at the key reasons:

• The psychological pain of losses is stronger than the pleasure of profit. The so-called ‘loss aversion’ was discovered by Daniel Kahneman and Amos Tversky. Their research showed that a person perceives the loss of $100 approximately twice as hard as the joy of earning the same $100. That is why an investor often prefers to do nothing, just to avoid the emotional pain of fixing a loss. Even if closing a position and accepting losses is rational.
  
  
• Hope of bounce. One of the most common scenarios is that the investor continues to hold the securities with faith in its quick recovery: ‘Just a little more, and the stock will turn around.’ At this stage, the investor can ignore negative news, worsening financial indicators and important changes in the industry. Hope replaces analysis, especially if a ‘miracle bounce’ has already occurred with other assets.
  
  
• Reluctance to admit a mistake. It is psychologically difficult to accept that you were wrong. Especially if it was a ‘public deal’ – for example, the investor discussed it with friends beforehand or recommended it to subscribers on a blog or social networks. In such a situation, fixing a loss is perceived as a blow to self-esteem or a ‘loss of face’, although in practice, mistakes and losses are a normal part of the investment process.
  
  
• No exit strategy. When an investor has not defined the rules for closing a position in advance, they find themselves trapped in uncertainty. This is especially true for beginners who do not ask themselves questions like: ‘At what level am I willing to sell the stock if things go wrong?’ As a result, they find themselves paralyzed: the deal gets hung up, time is running out, and losses are mounting.

How to Avoid Psychological Traps: Practical Recommendations

1.    Formalize the decision-making process

• Set clear entry and exit rules: Let's say, sell an asset when it falls by 20% from the purchase price or when key metrics deteriorate - debt growth, business marginality decline, net loss for the quarter or year. You can also use technical signals on the chart to exit - breakthrough of the support level, breakdown of the trend or crossing of long-term moving averages. The more formalized your algorithm, the less extension for impulsive decisions.
  
  
• Use Stop Loss and Take Profit - especially in short-term trading. These instruments allow you to fix the acceptable level of risk and potential profit in advance. And most importantly, they eliminate the human factor when reaching the designated levels - the position is closed automatically.

2.    Keep an investment log

• Record the reason for buying each stock. Such reason can be fundamental (revenue growth, unique product, undervaluation by multiples) or technical (reversal pattern, strong level, good risk/reward). Such log allows you to evaluate not only the result, but also the quality of the decision made.
  
  
• Record targets, holding periods, and position exit triggers. This will help avoid uncertainty when the market goes against you. Pre-determined rules make it easier to close positions without unnecessary hesitation.
  
  
• Review your records regularly and ask yourself, ‘Would I buy this stock today?’ This question helps combat asset bias and update your portfolio based on current information.

3.    Do not personalize losses

• A loss is not a failure or a threat to your reputation, but part of the process. Even the best investors in the world have drawdowns. There is no strategy, in which absolutely all trades are profitable. The goal is not to avoid losses at all, but to make them manageable and reasonable.
  
  
• Capital must work efficiently. If an asset does not meet the goals of the portfolio, it must be replaced, no matter how ‘painful’ it is to sell. A losing position that you hold because of emotions does not provide growth, and can deprive you of the opportunity to enter a more promising asset. There are always thousands of them on the stock exchanges.

4.    Create crises templates

• Think in advance how you will act in the event of a market collapse. For example, will you partially fix your losses, switch to cash, buy additional protective assets such as gold, dollars, bonds, or, conversely, average out in case of a quick recovery. Such plan removes panic and allows you to act clearly in an unstable situation.
  
  
• Conduct portfolio stress tests: which assets are most vulnerable to a 20%, 30%, 50% drop? Model different scenarios and think how balanced is your portfolio? Does it have a hedge? How mentally prepared are you for a drawdown?

5.    Isolate yourself from the ‘noise’

• Limit your time in news feeds, social networks and trader chats. Most news has no practical value for your strategy, but can cause an emotional reaction and provoke rash actions.
  
  
• Focus on strategy, not short-term volatility. Evaluating every drawdown or rally without considering the big picture often leads to overtrading. If you are trading based on long-term goals, don't let short-term noise throw you off course.

How Behavioral Finance Is Being Applied to the Modern Investment Industry

• Robo-advisors use typical client patterns to tailor investment recommendations. Such platforms analyze how an investors react to a rising or falling market: whether they are prone to panic, whether they quickly transfer funds to cash, or, conversely, increase risk. Based on this information, they offer strategies that are more suitable: from conservative to moderately aggressive. Some robo-advisors warn the user about the risks of impulsive actions, suggest taking a break before selling an asset at a loss, and give advice based on long-term goals.
  
  
• FinTech apps can consciously use behavioral triggers to stimulate trading and increase user involvement. It's simple - color signaling (green - growth and profit, red - decline and losses) instantly evokes emotions and thoughts. There are also push notifications with wording like "don't miss the opportunity" or "the stock is growing right now!" Sometimes they really help to pay attention to good deals. Nevertheless, you need to be vigilant and not fall under the FOMO influence - the fear of missing out. There is also gamification - accrual of points, badges, and ranks. Investments turn into a "game", and the user is more interested in making more deals.
  
  
• Funds and asset management companies incorporate behavioral factors into asset management algorithms. For example, they take into account seasonality and behavioral patterns of retail investors: such as the effect of the January rally, the increase in activity prior to dividend payments or mass selling during the tax settlement period. Based on these observations, funds adjust the timing of trades, the liquidity balance, and even create behavioral indicators that track collective emotions in the market - the ‘Fear and Greed Index’, the volume of inflows into ETFs and retail brokerage platforms.
  
  
• Modern Research: Those interested in behavioral finance should also pay attention to the papers of Richard Thaler. He is an outstanding American economist, winner of the 2017 Nobel Prize in Economics. He can be considered one of the founders of behavioral economics along with Kahneman and Tversky, and his discoveries can be dedicated to a separate article.

Behavioral Finance and High-Frequency Trading (HFT)

It is interesting that on modern exchanges, HFT algorithms, computer programs that make thousands of transactions in a fraction of a second, account for 50% to 70% of trading turnover. The question arises: Is there any place for psychology in a market where most decisions are made by machines?

In fact, yes - in spades! Many algorithms are specifically designed to monitor the behavior of ordinary investors and use their emotional reactions to their advantage. Moreover, some of them even try to trigger these reactions: for example, they create the appearance of a strong price movement so that other participants start to panic or buy on emotions.

It turns out that psychology has not disappeared – it is simply ‘sewn’ into the algorithms.

• HFT programs analyze the behavior of retail investors. For example, they track order surges amid news, recognize panic selling, and use this for scalping and arbitrage.
  
  
• Some algorithms imitate behavioral patterns to cause a reaction of other participants: form false orders (spoofing), test support/resistance levels relying on typical trader mistakes.

Conclusion

Rationality is a rare guest in financial markets. Even professional investors are not immune to emotional decisions. However, understanding the nature of behavioral bias allows building a system, where emotions do not control actions.

Investing is not just a guessing game. It is a discipline in which mental toughness is often more important than analytical skills. Those who can control their behavior have a chance to ‘beat’ the market – if only because they do not interfere with themselves.