There are numerous investing strategies that can make you rich. People often try to discover the secrets of successful investors or look for guidance in charts, graphs and statistical models. And yet, science shows there is more to investing than rationale and logic. Behavioural finance is an exciting field of research that studies the influence of psychology on the behaviour of investors or analysts and even wider market tendencies.
What Is Behavioural Finance?
Human behaviour is a complex mix of biological instincts, impact of social and cultural norms, and emotional reactions. It is sometimes better controlled by one’s mind, but in other cases hormones and emotions are in charge.
Although finance may seem a rational and predictable field of numbers and automated technology, volatile human behaviour often creates unexpected outcomes for financial markets. It is especially true when one deals with investing and trading.
Behavioural finance is a branch of financial and economic research that focuses on psychological foundations behind personal financial decisions. The studies suggest that the behaviour of investors or financial analysts often depends on their deeply embedded emotions, cognitive biases, and other psychological biases.
Moreover, their irrational investing choices have subsequent effects on global markets, which is another subject that needs additional research.
Challenges of Investing Choices
Decision-making is rarely easy, especially when it comes to money-making. Financial well–being is one of the crucial aspects of one’s social life, being closely linked to the satisfaction of most material and even some spiritual needs of an individual. Therefore, people care a lot about their budgets, prosperity and long-term financial goals.
At the same time, numerous self-help “How to..” types of books dedicated to the psychology and principles of money management indicate an acute lack of necessary skills in the majority of the human population. What might hinder a person to become a good investor? There are a number of associated challenges.
- lack of knowledge and experience which leads to intuitive and poorly informed but not necessarily correct decisions or makes one fall for unprofessional advice and even scams;
- misjudgement of own goals and risk tolerance may entice a person to blindly follow investment strategies of a certain business person or influencer, which is not always appropriate in any given conditions;
- redundant information about financial opportunities is currently available on all social platforms, news outlets, investment websites, etc., yet it is not always reliable and trustworthy;
- uncertainty which always comes along with one’s awareness of investment risks and volatile market conditions might block the investor’s decisiveness and prevent them from grabbing good financial opportunities;
- overwhelming emotions such as fear, greed, and overconfidence can influence investment decisions, especially in times of rapid market changes and unpredicted fluctuations;
- complex market conditions may seem too confusing for novice investors and the added influence of external factors makes market dynamics even more difficult to grasp without professional help.
As we see, there are some pretty objective reasons why investing may be challenging for a person. However, maintaining discipline and objectivity amid the additional pressure of market turbulence can be even more complicated for emotional people. Here’s what behavioural finance has to say about that.
Investor Emotions vs Rationale: Who’s in Charge?
To understand how emotions and psychological reactions influence investors’ decision-making processes, researchers combine the knowledge bases of economy and psychology. Unlike traditional finance, this field of study assumes that investors are not always rational and often act impulsively due to cognitive biases, emotions, and social influences rather than making informed decisions in their best interests.
Behavioural finance has made a few important findings that illustrate the basic principles of investment psychology. To begin with, this science explains that irrational decision-making is often triggered by cognitive biases.
The Role of Cognitive Biases in Investing Decisions
Cognitive biases are systematic errors in thinking that occur when the human brain is trying to simplify the interpretation and processing of the information it receives. Such errors may be linked to memory and attention deficits.
The examples of cognitive biases are:
- paying attention only to news stories or arguments that confirm your opinions, but not the opposing ideas;
- blaming external factors for your own mistakes instead of taking responsibility;
- denying diversity of opinions and beliefs;
- making assumptions based on limited information;
- relying too heavily on the very first piece of information you learn about the subject;
- rely on prejudice and generalisations.
Cognitive biases can affect decision-making in many areas including social behaviour, cognition, behavioural economics, education, management, healthcare, business, and finance.
In personal finance and investing, one may fall victim to several biases. For example, an investor may not like the financial consultant or real estate agent as a person and consider their offering to be a bad investment based on subjective perception rather than actual deal details. Or else, you might like a risky investment opportunity and take into account only the arguments in its favour, but not logical precautions.
In addition, investors may rely on past performance instead of current trends to predict future returns. They can fixate on a single investment strategy totally ignoring others. That leads to misconceptions and investment mistakes.
Finally, when you make a poor investment decision, you would rather blame it on, let’s say, market volatility due to geopolitical changes than your own lack of research on the subject. On the other hand, when someone invests successfully, you as an observer would attribute that to pure luck and not a brilliant investment strategy.
Emotions Lead to Market Volatility
As if mental shortcuts affecting our logical thinking weren’t enough, investors often don’t use logic at all, being overwhelmed by emotions.
Investors may experience fear of missing out or losing money which distorts their rational perception of risks and gains. Greed prevents investors from timely fund withdrawal or strategy change, while overconfidence or excess optimism makes one believe that they are less likely to suffer from misfortune and more likely to be successful than their peer investors in the same position.
When feelings are too powerful, investors may rush to sell assets at depressed prices or, vice versa, to buy a novel asset that’s getting popular at the time, without thorough analysis. This urge goes along with herd behaviour – the tendency of individuals to follow the actions of the crowd, whether they’re rational or not. Herding leads to both market bubbles and crashes. Even when the scope of herding behaviour is limited, investors’ emotional rollercoaster is still often accompanied with market ups and downs. Multiple research evidence has shown that investor sentiment and overreaction plays a significant role in international market volatility.
The most susceptible to market volatility are riskier, smaller cap and less profitable stocks. Their market status may change abruptly due to positive or negative investor sentiment that has nothing to do with logic. The same is true for crypto assets. Crypto enthusiasts surely remember how the market value of Dogecoin surged and plummeted over a single speculative tweet in the past.
In Uncertain Periods Negative Emotions Prevail
Typically, a stable financial and economic environment doesn’t drive the urge to make irrational decisions unlike market turbulence. Prospect theory, developed by Daniel Kahneman and Amos Tversky, explains that individuals are more sensitive to losses than gains. It is even more true in uncertain conditions. People tend to make decisions based on perceived negative changes and risks. At the same time, they may ignore general statistics or optimistic forecasts. Therefore, investors often exhibit risk-averse behaviour in the face of potential losses and amid economic downturn.
Some of the market anomalies cannot be explained by traditional finance theories and rationale. For example, the momentum effect (when stocks that have performed well in the past tend to continue performing well) and the value effect (value stocks tend to outperform growth stocks over the long term) are contrary to the traditional finance theory.
While the traditional theory says it’s impossible to predict continuously profitable trading strategies, past winners continue to outperform past losers and that is explained only by behavioural finance theories (like people relying on past performance rather than current trends). The superiority of value stocks may be attributed to risk-aversion associated with frequent economic crises. When another crisis hits, the first thing many investors do is sell out ‘risky’ growth stocks for fear of losing money and re-invest into something perceivably stable. A perfect illustration is the forever-growing value of gold treated as a ‘safe haven’ asset for ages.
How to Overcome Bias and Emotion and Make Rational Investment Choices?
As emotions and bias do not belong to the realm of conscious reactions, it may be easy to fight their influence over your decisions. However, there are some tricks and techniques that may help you regain control over your financial well-being.
- Start with awareness – to overcome the impact of bias on your rationale, you should be aware of the types of cognitive biases and mental shortcuts and systematically analyse your decision-making to detect irrationalities.
- Develop critical thinking and dedicate more time to research – think about the assumptions you make about a particular market asset or investment strategy. What are they based on? Don’t rely on a single source of information. Check the validity and assess any theories critically. Take your time to analyse counterarguments.
- Challenge your biases – if you notice you have a certain cognitive bias, e.g. blaming external factors instead of yourself for the investment failure, challenge that misconception intentionally. Acknowledge your mistake and focus on noticing and challenging similar logical flaws from now on. In some difficult cases, you may even seek professional help.
- Try cognitive bias modification therapy (CBMT) – if you can’t handle that alone, and the biases significantly affect your finances and personal life, try a professional treatment designed to reduce cognitive bias, as well as treat addictions, depression, and anxiety.
- Practice mindfulness and emotional regulation – meditation, deep breathing exercises, and cognitive reframing can help a person get in better contact with their emotions, and stay calm and focused during decision-making.
- Use decision-making tools – checklists, decision matrices, and decision trees can help individuals structure their thinking and reduce the influence of biases. Take your time to figure out what the issue or opportunity is and make informed decisions based on multiple data points.
