Understanding Behavioural Finance: How Psychology Influences Decisions in Investment

This was originally posted on Planner Bee.

Have you ever wondered why you sometimes make irrational decisions with your investments? Do you find yourself holding onto loss-making stocks for too long or jumping on the latest investment trend without thorough research?

These behaviours are not random, but are deeply rooted in your psychological biases. Unlike traditional finance, which assumes everyone makes logical decisions, behavioural finance recognises that people often act irrationally due to emotions, cognitive errors, and social influences. These hidden psychological forces can negatively influence your investment choices.

This article will explain key ideas in behavioural finance, common psychological biases, and how these can affect your investment decisions.

What is behavioural finance?

Behavioural finance, a subfield of behavioural economics, explores the psychological factors influencing financial decision-making.

It challenges the traditional view of perfect rationality in financial markets, acknowledging the role of emotions, biases, and cognitive limitations in shaping an investor’s behaviour. Understanding these factors can allow you to make more informed choices and avoid costly mistakes.

Key concepts in behavioural finance

Behavioural finance combines psychology and finance to explain why people make certain financial decisions. Some important ideas are:

• Framing effects: The way information is presented significantly impacts choice. Investors might favour options framed positively over those framed negatively.
• Bounded rationality: Humans have limited cognitive abilities and struggle to process complex information perfectly. We rely on mental shortcuts to simplify decision-making, which can lead to biases.
• Prospect theory: Developed by Daniel Kahneman and Amos Tversky, prospect theory describes how individuals value gains and losses differently. Losses are felt more acutely than gains, leading to risk aversion and other biases.
• Mental accounting: We categorise and track money, treating funds in different accounts differently. This can lead to inconsistent investment decisions based on mental compartments.

The power of biases

Our brains are wired to take mental shortcuts.

More often than not, we tend to rely on heuristics or rules of thumb to simplify complex situations. While these shortcuts are generally useful, they can also introduce systematic biases that distort our financial judgments.

These are some of the common biases that affect investment decisions:

1. Loss aversion

Based on prospect theory, humans feel losses more acutely than gains. As a result, this can lead to:

• Selling investments prematurely: Investors might sell losing investments to avoid further losses, even if the long-term outlook remains positive.
• Holding onto losing investments: Fear of locking in losses can lead to clinging to failing investments in hopes of a rebound.

This emotional rollercoaster can ultimately hurt investment returns, as either selling too early or holding onto losers for too long can be detrimental to a healthy portfolio.

2. Anchoring bias

We tend to rely too heavily on the first piece of information we encounter, which can lead to:

• Anchoring on initial stock prices: Basing investment decisions solely on the initial purchase price, neglecting subsequent market movements.
• Over-reliance on analyst recommendations: Giving excessive weight to analyst opinions without conducting independent research.

Over-reliance on a single piece of information can lead to fixation on the starting point and overlooking valuable new insights, ultimately missing the bigger picture.

3. Confirmation bias

Confirmation bias occurs when one favours information that supports their pre-existing beliefs about an investment. This often results in:

• Overconfidence in investment choices: Holding onto losing investments because they align with initial beliefs despite negative market signals.
• Ignoring valuable information: Failing to consider alternative perspectives that might improve investment decisions.

When new information emerges, they readily accept it to validate their investment decision, even if the information is flawed.

4. Herd mentality

Humans are social creatures and we tend to mimic and be influenced by the behaviour of others. This form of bias is usually one of the causes behind massive rallies and sell-offs. These are just some of the fatal flaws of adopting a herd mentality:

• Following the crowd: Investing in popular stocks without proper individual analysis, potentially entering overvalued markets.
• Missing out on opportunities: Ignoring potentially valuable investments because they are unpopular.

Blinding following exposes you to unnecessary risks and can potentially cost you amplified losses during a market downturn.

5. Overconfidence bias

We frequently overestimate our knowledge and abilities. This common tendency causes many to believe they are more skilled and informed than they really are, which can lead to misguided decisions and actions.

Here are some other pitfalls of being overconfident in one’s knowledge:

• Taking on excessive risk: Investing in highly volatile assets without considering the potential for significant losses.
• Neglecting diversification: Concentrating investments in a few sectors or asset classes increases overall portfolio risk.

Overconfidence can lead one to dismiss valuable advice and result in a reluctance to learn from others, hindering your ability to become a better investor.

Read more: Avoiding Investment Scams: Red Flags To Watch Out For

Impact of emotions on financial decisions

Emotions play a powerful role in financial decision-making.

These are some key emotions that are commonly associated with investing:

• Fear: Often manifests during market downturns or economic uncertainty, prompting investors to sell their investments hastily out of panic. This reactive behaviour can result in missed opportunities for potential recovery as markets fluctuate.
• Greed: The desire for quick and substantial profits, which can result in chasing high-risk investments and overvalued assets in pursuit of quick profits. This desire for immediate gains can cloud judgment, leading to investments in assets that may be overvalued or prone to significant volatility.
• Regret: Stemming from past investment mistakes or missed opportunities, leading to hesitation and indecision in future investments. The fear of making a wrong choice can lead to indecision or paralysis, causing investors to miss out on favourable opportunities.
• Overconfidence: The belief that one’s knowledge or abilities are superior, which can result in taking excessive risks and neglecting proper research.
• Hope: The optimism that investments will perform well, which can sometimes lead to holding onto losing investments for too long. With the thrill of potential gains, being overly hopeful can drive impulsive and speculative investment decisions.
• Frustration: Resulting from poor investment performance or market volatility, leading to impatience and potentially irrational decisions.

Mastering your emotions and keeping them within control is crucial for making rational investment decisions that align with long-term financial goals.

Behavioural finance in market anomalies

Behavioural finance also sheds some light on market anomalies, instances where market behaviour deviates from the efficient market hypothesis.

Here are some examples:

• Disposition effect: Investors tend to hold onto losing stocks hoping for a rebound while readily selling winning stocks to lock in profits. This creates a market inefficiency where undervalued stocks are more readily available than overvalued ones.
• Momentum investing: Investors chase recent winners, pushing prices higher, even if the underlying fundamentals do not justify the rise. Behavioural biases like overconfidence and herd mentality can contribute to this phenomenon.

Understanding these anomalies can help you recognise potential pitfalls and opportunities in the market.

Closing note

The world of finance may seem complex and intimidating, but understanding behavioural finance can empower you to make smarter investment decisions. By recognising how our emotions and cognitive biases can influence our choices, we can become more aware investors.

A successful investment strategy is built on a foundation of self-awareness, discipline, and a long-term perspective.

Don’t be afraid to seek professional guidance and conduct your research to avoid getting caught up in the emotional rollercoaster of the market. Take control of your financial future by harnessing the power of behavioural finance!