Behavioural finance: The effect of psychology on investors
You should base financial decisions on logic and facts. But psychology can have a much larger effect than you think, and it can lead to you making decisions that aren’t right for you. Read on to find out more about what behavioural finance is and how it could affect you.
“Behavioural finance” was first coined in the 1970s by economist Robert Shiller and psychologists Daniel Kahneman and Amos Tversky. They used the term to refer to how unconscious biases and heuristics affect the way people make financial decisions.
It can be used to explain why investors can make knee-jerk decisions or invest in opportunities that aren’t in their own best interest. Rather than relying purely on facts, investors often have biases that affect how they react to certain situations.
In this article, find out more about where biases can come from and why they can have such a large effect on your mindset. Over the next few months, we’ll explore specific examples of how financial bias can affect your decisions and what you can do to make better choices.
Finance bias can lead to “irrational” decisions through shortcuts
There’s a reason why people often make decisions based on biases: they can make the decision-making process quicker.
If you imagine how many decisions you need to make every single day, it’s easy to see why this kind of decision-making can be useful. From what to eat for breakfast to which way to travel to work, it’d take up all your time if you carefully went through the facts for each decision you make. So, you make shortcuts by using biases.
However, while it can be a useful process in your day-to-day life, bias can have a negative effect when you’re making important decisions, including financial ones.
Behavioural finance covers five concepts:
1. Mental accounting
Mental accounting can be incredibly useful when you’re managing a budget. However, inflexibility could mean you miss out on opportunities.
The concept refers to how people may designate money for certain purposes. So, you may have different savings accounts for various goals. It’s a process that can help you manage your outgoings and work towards goals.
However, it can also lead to irrational decision making.
You may not dip into a savings account that you’ve allocated to buying a new car even when you face an emergency and it’d make sense logically.
How you receive the money may also affect how you use it. For instance, you may put off using money that was given as a gift in an emergency because you believe it should be used for something special.
2. Herd behaviour
Herd behaviour is something that’s often seen in investing. When you hear that lots of people are selling certain stocks or buying a specific share, it can be easy to be led by this and follow suit.
It can lead to you making decisions that, while possibly right for others, don’t suit you or your circumstances.
It’s not just investing where herd behaviour can have an effect. You may be tempted to purchase an item after a friend has or choose a savings account because someone you know has.
When you have some information, you may focus on this – anchoring your views to this data.
Setting a benchmark can be useful, but it can mean you don’t take in other information, especially if it’s contradictory.
So, you may hold on to investments even after the value has fallen because you’ve anchored its worth to a previous valuation.
4. Emotional gap
Emotions often play a role in financial decisions. You may sell a stock because you fear that the price will fall, or make an impulse purchase because you’re happy.
Being comfortable with your financial plan is important, but an emotional gap can fuel irrational decisions as you’re more likely to overlook data.
This concept refers to how investors are likely to have overconfidence in their abilities.
You may believe you can reliably time the market to maximise profits when the markets are unpredictable. In this case, it’s common to see “wins” as being down to your knowledge, while “losses” are attributed to things outside of your control.
Unconscious bias may affect your decisions in ways you don’t expect.
Next month, read our blog to understand some of the common ways that biases could affect how you think about money and respond to circumstances. Learning more about how bias may affect your financial decisions can help you make better choices in the future.
If you have any questions about your finances and the decisions you need to make, please contact us.
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.