In an attempt to understand why rational investors make irrational and emotional decisions, academics and experts turned to behavioural psychology.
What is behavioural finance?
Behavioural finance is the field of study that combines psychological theory with conventional economic theories in an attempt to interpret and make sense of why investors make irrational decisions despite displaying rational financial sense.
Behavioural finance questions the irrational investment decisions of investors who follow logical and reasonable financial strategies. This is done by analysing how their biases with regard to money influence their financial decisions.
Key points of study in behavioral finance
Behavioural finance is concerned with anomalies in the concept of ‘homo economicus’—or the idea that humans are wealth maximisers that can apply reasonable decision-making processes with their money.
Here are some of the irrational behaviours that investors exhibit, according to experts on behavioural finance:
- Confirmation bias
- Mental accounting
- Gambler’s fallacy
- Prospect theory or loss aversion
Overconfidence refers to the fact that most investors, especially professionals, believe themselves to have above average skills and performance.
In reality, such a belief leads them to be more aggressive with investments and expose their portfolios to greater risk. A 1998 behavioural finance study by Terrence Odean suggests that overconfident investors tend to trade more yet reap significantly lower yields.
Herding is the tendency of investors to make investment choices based on the majority decision—or the pressure to conform. The premise is that “if the majority is doing it, it’s probably the right choice”.
This behaviour can usually cause rallies, bubbles or dead cat bounces which could prove detrimental if an inexperienced investor falls for the hype.
Confirmation bias refers to some investors’ tendency to be biased in their acceptance of information when they research. This happens when they accept favourable information about products they plan to invest in and reject the unfavourable ones.
Mental accounting is the tendency to allocate money in different containers based on different criteria or perceived use. For instance, people would set up money jars or different savings accounts for vacation, weekly spending budget, house or car deposit and they treat each of those allocated money differently.
When it comes to investments, some investors apply mental accounting by owning multiple portfolios with different levels of risk.
Anchoring is the tendency for people to base their financial decisions to certain references regardless of the facts. For instance, a person may think that an investment fund with truly capable managers charges three to four per cent a year in fees based on their rich friend’s multi-million dollar portfolio.
In this sense, the person may opt for investing with the same fund manager or basing other fund managers’ capabilities on how much they charge in fees, even if the reason for a large gain in their friend’s portfolio is a bull market and a large principal investment.
A classic example of gambler’s fallacy is when a person hangs on to a game despite successive losses, sure that the next one will be a big win.
When it comes to investing, this may come in the form fear of opportunity loss because an investor may wish to hold on to a losing investment in the hope of future recovery. The opposite also holds true because some investors may consider selling their investment if it already increased in value several times consecutively, sure that it can only go downhill from there.
Prospect theory or loss aversion
This theory holds that, when faced with two choices that yield the same result, humans have the tendency to choose whichever option seems to avoid loss.
Consider the following scenario and decide which one is better:
- A friend who owes you $100 suddenly visits to pay their debt; or,
- A person accidentally flushes $100 down the toilet but they win the $200 minor prize in a contest the same day.
Those who selected choice A as the better scenario exhibits this loss aversion.
The theory suggests that, when faced with a financial decision, people tend to consider the weight of potential losses over gains and select whichever is perceived to minimise loss even if gains are smaller. Experts suggest that investors have the tendency to feel the sting of loss longer than the joy of gains.
How big is the discipline?
Behavioural finance is a relatively new field of study that started roughly in the late 1970s or early 80s, which means that the discipline is still growing. However, there are already two Nobel Prize winners in the discipline.
Cognitive psychologist Daniel Kahneman, who is considered as co-founding father of behavioural finance, received the Nobel Memorial Prize in Economic Sciences in 2002.
Richard Thaler also received the Nobel Memorial Prize in Economic Sciences in 2017 for contributions to the field. Read more about Richard Thaler and his work in “How your mind hurts your saving habits: Nobel winner”.
This information has been sourced from the Investopedia and Nest Egg.