Meet homo economicus.

He’s a guy who inhabits examples presented in financial theory textbooks.

When it comes to investing, he’s a cold, calculating machine, who gathers all the available information before making an entirely rational decision.

Thanks to homo economicus, financial market prices are accurate all the time. They reflect logical thinking and all the facts.

In reality, though, almost nobody is like this theoretical character.

Instead, we humans all too easily make decisions based on partial information, rumors, our own emotions and the din of the crowd around us.

As a result, we make mistakes. Good assets get dumped too cheaply during panics, while people routinely overpay for investments because everyone else is eagerly buying them too.

But what if we could understand a bit more about what makes us tick?

Perhaps then, we could avoid some of the common pitfalls and potentially improve our performance over time.

Welcome to the world of behavioral investing.

Behavioral investing looks at how the workings of the mind influence investing decisions and financial markets.

It comes from the work of leading economists and behavioral scientists who reject the traditional view of people as rational, ruthlessly self-interested calculators. 

Instead, they look at how humans really behave, both in simulated situations and in real life.

The evidence, they say, is that human feelings, habits and biases constantly affect how we act.

Here are some of the main tendencies they’ve identified and how they impact investors.

When it comes to weighing up evidence, investors tend to focus too much on recent events.

That may be because those events are fresh in our minds. But this tends to obscure other important information just because it isn’t at our fingertips.

Such thinking can lead investors to believe what’s happening right now will keep going, despite evidence from previous episodes.

This often causes people to buy during bubbly conditions and sell during panics, even though history tells us that both are bad ideas.

Investors have an unfortunate habit of selling investments that do well too early and hanging on to those that perform badly for too long.

This is because the human mind likes to register successes but avoids having to admit failures.

We should, instead, recall the old investment adage: “run your profits and cut your losses.”

With a flood of information rushing over us each day, our minds have to take shortcuts.

So, when a new piece of information comes our way, we tend to form judgements based on preconceived notions rather than looking at the facts on their merits.

One example of this is where investors analyze a stock only in the context of its recent performance rather than assessing fresh, forward-looking data.

Keeping an open mind and seeing the bigger picture are thus vital to avoid flawed decisions.

We tend to get emotionally attached to the things we own – not just homes and prized possessions – but also financial investments.

One effect here is that we can mentally price an asset at more than it’s worth and fail to see its shortcomings.

Taking a dispassionate, data-driven view can help here.

Or, as the old saying goes, “don’t fall in love with your stocks, as they sure won’t fall in love with you.”

When other investors are flocking in or out of certain investments or asset classes, we often get swept along. This behavior feeds into bubbles and busts.

Many people believe that these other investors must know more than us and develop FOMO, or “fear of missing out.”

Blindly buying or selling is always to be avoided, however. We should respond to mass exuberance or despondency with skepticism rather than embracing it.

Recognizing that we humans are prone to flawed behaviors is an important step.

The next step is to try to prevent ourselves from succumbing to these biases.

And perhaps also to turn the biases of other investors into potential opportunities for ourselves. 

Here are three habits we can consider to improve our investing behavior:

Establish and follow a long-term investment plan. Having measurable goals and an objectively determined strategic asset allocation to pursue them can help you avoid getting caught up in irrational episodes.

Keep an investing “diary.” Use it to set out the logic for a potential investment, target return, the risks and what would undermine your case. After completing an investment, revisit and note down what went well or badly. 

Seek out opposing opinions. Rather than trying to confirm your own viewpoint, seek out an analysis that conflicts with your thinking. Read what the bears say about your favorite stock. Listen to credible sources predicting the downturn that no one else is expecting.