Even experienced and knowledgeable investors can make investment blunders based on mistaken beliefs about financial markets or as a consequence of emotional reactions to market developments. Behavioural finance is the field of study combining aspects of psychology and economics to try to explain the theory behind investor behaviour—especially the behaviours that can lead to irrational decisions.
Understanding behavioural finance may help you recognise your own biases. Financial markets aren’t intuitive, and in many ways, our human brains aren’t capable of fathoming the complexity involved in financial markets. This can make it difficult to tell if you are making an investment decision based on facts or feelings. Following your instincts may make sense in many situations—but not always in the investment universe.
Studying or becoming aware of how human psychology affects investor behaviour in finance and economics isn’t a perfect solution to avoiding making any future financial mistakes. However, understanding some key behavioural finance concepts along with your own biases can help you recognise when you might be reacting emotional and could potentially save you from common investing mistakes.
In this article, we will help by describing some common biases found in behavioural finance.
Loss aversion: Loss aversion is a theory that humans tend to feel the pain of a loss more intensely than they feel positive feelings about a similarly sized gain. If an investor experiences significant market losses, such as those encountered during a market downturn, loss aversion may lead them to become fearful of markets and overly conservative or avoid assets with more market volatility. However, if you need long-term growth in your investments to achieve your financial goals, investing in low-yielding, conservative assets may not provide the necessary growth to achieve those goals.
Confirmation bias: Confirmation bias describes humans’ tendency to only look for and accept information they agree with, and ignore anything they don’t agree with. Seeking out information to confirm your thoughts or theories and ignoring anything that doesn’t support your opinions may lead you to overlook important information. Investors may overlook reliable sources and data just because it doesn’t fit in with what they currently believe.
Recency bias: Recency bias is the tendency to let recent trends influence your outlook on what will happen in the future. For example, if equities have been positive lately, you may think that means that trend will continue. Or if equities have fallen consistently recently, you may assume that they will continue the downward trend. However, equities and other assets do not necessarily move in an exactly straight line, and past performance is not indicative of future performance.
Overconfidence: Are you more knowledgeable than other investors? Have you made a successful investment decision in the past, and therefore believe you have the skills to continue doing so? If you made a poor investment decision in the past, do you believe it was just because you were unlucky? If so, those are thoughts that may be attributed to the human tendency to attribute their successes to skill and their failures to bad luck. If you believe this, you may have the tendency to make the mistake of overconfidence when investing.
Overconfidence can lead to investment decisions that may not be the best choice to meet long-term retirement goals. For example, if you are overconfident in all of your investment choices, you may be tempted to put a large amount of money or the bulk of your savings into just a handful of stocks—or even a single security. Do you know for certain that a company’s security will continue to rise? Are you willing to stake your entire retirement savings on that confidence? Overconfidence could lead to increased risk taking, which can be dangerous.
We have discussed some common behavioural biases and key concepts, but there are many other behaviours that may lead people to make investing mistakes. Additionally, keep in mind that not every article or theory labelled as behavioural finance or economics should be taken to be perfect or a solution to making difficult investment choices.
So how can you avoid these biases or pitfalls? Simply being aware of them is a good first step. However, being able to identify your own behavioural biases can be difficult. Investors may believe that they have sidestepped making a common mistake, while jumping headfirst into another.
To help identify your own biases, ask yourself:
Your brain didn’t evolve to intuitively understand economics and finance. In fact, the human brain has a number of tendencies that can cause missteps in the financial world. It may seem overwhelming to have to try to account for all of your behavioural tendencies when making investment decisions. Before making a decision, think about where your natural human tendencies may be leading you astray, and truly get to the root of your decisions and how they align with your long-term goals.
Maintaining a rational decision-making strategy when it comes to your finances and investments can be difficult, and feeling emotional or concerned during times of market volatility is normal! However, controlling those sometimes reactionary emotions and remaining level-headed and rational can be crucial for long-term financial success.
Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.