Human behaviour, especially when it deviates from rational decision-making, has become increasingly significant in the realm of modern investment strategy; traditional economic models’ expectations of rationality no longer paint the whole picture. By applying psychological principles to economic analysis, behavioural economics adds nuance to the investment decision-making framework of individual investors. This interdisciplinary approach creates awareness that investors are subject to cognitive biases, emotions, and social factors: the most critical factors affecting their choices and the market. These human behavioural elements are essential for the development of an appropriate model that will be able to account for powerful and complex human psychology.

The overconfidence effect is the anchor that causes individuals to attribute false knowledge of themselves, impeding their judgments. CEOs may display a tendency towards overconfidence by overlooking the risks and sticking to overly optimistic forecasts. The same can happen to private investors who take risks excessively and neglect principles of diversification because overconfidence has distorted their decision-making process. Over time, the overconfidence effect can harm the return on investments. Being cognizant of and tackling this bias is essential in reaching successful investment outcomes and preventing undue risks. Psychological biases such as overconfidence consistently influence people’s investment decisions, making them unpredictable and sometimes irresponsible.

Loss aversion is the propensity of humans to be more sensitive towards losses than equivalent gains. Investors often struggle with the conflict between rationality and emotion in their decision-making. For instance, they may hesitate to sell underperforming assets due to loss aversion, prioritizing avoiding losses over maximizing gains. This conservative approach extends to portfolio construction, where investors may favour safer assets to mitigate uncertainties. However, this aversion to loss also reflects a broader discomfort with risk-taking, leading investors to opt for conservative strategies over potential growth opportunities. The inherent risk aversion might contribute to the problem of underperforming portfolios due to reduced potential gains and poor allocation of resources in different asset classes. Knowing the impact of loss aversion and investment decisions can help investors create a solution to exempt such an effect and make rational and well-examined investment decisions.

Further, anchoring bias may also play a role when making an investment decision. This bias is a cognitive phenomenon whereby individuals rely excessively on the initial information (the anchor) when making a decision. In the realm of investment, this bias shows up when the person making the decision gets carried away with one particular anchor to which they attach their mind, such as the purchase price of a stock or recent market trends. For example, an investor might anchor their valuation of a stock to a localised high price, resulting in inflated valuations and irrational investments. Another pitfall is the status quo bias, where investors may choose to remain with their allocation despite changes in the investing environment or personal financial goals. Recognising the anchoring bias in valuation and asset allocation is critical for investors to make rational investment decisions. 

Examining how behavioural traits shape investment decisions underscores the enduring impact of psychological biases on investor behaviour. Addressing biases such as confidence bias, loss aversion, and anchoring bias is crucial for investors to optimise outcomes. Through techniques like diversification and disciplined strategies, investors are able to navigate markets effectively.