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Tulip bulbs and bitcoins - welcome to the world of behavioral economy

Have you ever wondered how do we make decisions on the financial market? On the one hand, we would like to be considered reasonable, but the reality often looks completely different. The behavioral economy is focused on the mechanisms of such decisions.

It is worth looking at the history of markets to see how emotions play their role. To extremes are obviously greed and fear - they affect the moods on the markets to the greatest extent. In an advanced bull run we can assume that the greed wins on the market, however, if we reverse this trend, panic takes control.

Emotions have always been a part of investments. The perfect example is a bubble on the tulip market in the 17th century in Amsterdam, where astronomical amounts of money were paid for bulbs of specific tulip varieties (an equivalent of average real estate price). In 2017 we witnessed madness on cryptocurrency market when BTC/USD gained more than 1,000% and the niche market grew at a break-neck speed. Thus we can put it clear - markets change (tulip bulbs, cryptocurrencies, precious metals, spices, etc.), but the emotions and at the same time investors’ behaviors stay the same over time. We make many mistakes as investors; some of them result directly from our psychological conditions, and some are connected with the lack of knowledge or improper preparation for investments. I will present below four common investment mistakes and I will show you the reason behind them and the ways to avoid them.
Fear of closing a loss-generating position
We often act counterproductively, when we are scared of closing the loss-generating position. This is a result of a strong aversion to risk and the feeling that the loss is not real until it has been realized. And yet, mathematical calculations are unrelenting. If our position declines by 20% it means that we need to gain 25% to come back to the initial value. When we allow the position to decline by 50% it means it has to regain 100% to reach the initial value. The appropriate preparation prior to concluding a transaction minimizes the chance of making that mistake. While planning an investment, we should also take into consideration the scenario which we do not assume - market trends are often reversed contrary to our expectations. The question is what do we do in such situation? Do we have any “plan B” or we are going to watch it passively? Creating an additional plan should bring us relatively calculable effect and help us to get rid of decision deadlock, which we may experience in crucial moments.
A different attitude towards various funds because of their origin
A frequent mistake is “treating” the shares we did not buy differently if we received them as a form of additional remuneration or inheritance. A typical tendency is to keep those positions in the portfolio even if it is connected with a large concentration in one company and lack of appropriate diversification. One should ask oneself the question whether we would spend all money on shares of one company if we got cash. In most cases, the answer is “no”. We tend to book the funds we received in a different way than the funds we saved on our own.
Reverse certainty effect

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One of the cognitive mistakes is so-called reverse certainty effect. When we look at the market, we tend to simplify the reality and think that past situations were easy to predict. For example, the famous “I knew it”. In reality the market processes are activities in the area of uncertainty. While making an investment decision, we accept the related risk. Thus, it is beneficial to assume certain scenarios, plan what to do when our expectations are not fulfilled.  Risk management and appropriate diversification should be one of the key elements of the investment process.
Concentrating on the domestic markets
The next important aspect is to take foreign diversification into account. We usually tend to put more emphasis on the assets connected with the market which is closest to us. We think that we know and understand it better. For example, Poland “weights” in MSCI World index 0.1 percent only. It means that the prevalence of Polish shares in our portfolio is not an optimal way to build the share part of our portfolio. In case of a longer economic downturn on the Warsaw Stock Exchange (GPW), we may be disappointed with the result. Therefore it is essential to have an open mind and take global solutions into account.

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