Behavioural finance is a field that combines psychology, economics, and finance to better understand why people behave the way they do when it comes to money, and how that behaviour affects financial outcomes.
The field originated from the work of psychologists Daniel Kahneman and Amos Tversky, and economist Robert J. Shiller in the 70s and 80s. As such, it’s a relatively new area, but has already had a profound impact on the way economists, investors, and financial planners think about decision-making and financial markets.
One of the central insights of behavioural finance is that people are not always rational when making financial decisions. In traditional finance, individuals are assumed to act rationally, making decisions based on the best available information, and maximizing their own self-interest.
However, behavioural finance recognizes that real people don’t often act this way – instead, they are commonly driven by emotions, biases, and mental shortcuts when making financial decisions. This can lead to decisions that are not in their best interests and can have a significant impact on the financial outcomes they achieve.
Here are 9 key examples of how behavioural finance plays out and impacts financial decision making in real life:
1. Overconfidence – 90% of car owners believe they are above average drivers, which is of course impossible.
People often think they know more than they do, or tend to overestimate their own abilities, and it’s no different when it comes to their finances. This then leads to making investment decisions that are not well-informed, or leads to a tendency to take on more risk than they should.
For example, an investor might believe they can time the market perfectly, so they buy high and sell low. This is a classic example of overconfidence in one’s own abilities, which can lead to poor financial outcomes.
Similarly, overconfidence can lead to people trading too frequently, believing they can beat the market, when in reality they are more likely to incur losses.
2. Loss Aversion – a purely rational person would be just as happy with a gain of £1,000 as they would be upset with a loss of £1,000.
However, people are not always rational and tend to feel losses more deeply than they feel gains. Not only does this mean that investors sometimes favour investments that may not optimise returns because they offer limited downside (“protected or structured products”), it also leads to investors avoiding risk when they have already experienced a loss, or being reluctant to realise losses as part of an efficient portfolio or tax planning strategy. All of this can result in worse financial outcomes and prevent future gains.
3. Herding – People often follow the crowd, even if it means ignoring their own intuition, independent research, or professional advice. A fear of missing out on a fashionable trend overpowers logical thought.
For example, when the stock market is on a bull run and most assets are rising in value (picture a rising tide lifting all boats), many people will jump on the bandwagon of buying hyped up or high-flying stocks. Often, they don’t understand the underlying companies, and this can lead to large losses when the market eventually corrects itself, as “hot” market conditions were the only thing keeping these companies buoyant.
A few recent real-world examples of this would be:
a) the “dot-com bubble” of the late 1990s, as investors poured money into technology stocks despite little evidence of earnings or revenue.
b) Meme stocks, or even digital assets like crypto or NFTs, again showing little evidence of earnings or revenue.
c) Technology stocks in response to the COVID-19 pandemic – although some companies might have been a good investment early on in the pandemic given the boost to their revenues (e.g. Zoom), markets process information quickly and this was priced in quickly, however, flows continued to pour – or ”herd” – into technology stocks throughout most of 2020 regardless of the underlying businesses, resulting in dizzying technology stock valuations and a subsequent correction.
4. Mental Accounting – People tend to mentally separate money into different “pots” and treat each account differently.
Whilst this can be very powerful when done correctly and with structure, it can also cause huge issues when done more casually and only mentally. For example, someone might view their savings account as “sacred” and only use it in case of emergency, while they might view their credit card debt as “not real” and be more likely to spend freely. This can lead to financial problems down the road.
The same can happen with investments, for example, some investors will only touch income and vow never to touch their capital. In reality, this separation can be illusionary and have little relevance to an investor – for example, income from a bond valued above par is essentially partly a return of capital, or an investor who spends all distributions from an equity income fund is in reality spending a small amount of returned capital given the fund will take their charges from capital.
As such, the key takeaway here is to focus on total return and avoid over-emphasising the importance of its components.
5. Confirmation Bias – People tend to seek out information that supports their beliefs and ignore information that contradicts them.
For example, an investor might only seek out news articles that support their investment thesis, ignoring any articles that paint a more negative picture. This can lead to poor decision-making, as the investor is not getting a full picture of the situation and is acting on only partial information.
6. Hindsight Bias – the investment world is never short of people who can give detailed reasons for something happening, after it has already happened.
Because these explanations emerge so quickly and easily – whether they are correct or not – people can develop the feeling that the sequence of events was obvious and could have been predicted.
In reality, nobody has a crystal ball and such predictions were likely impossible.
7. Anchoring: Investors often anchor to numbers they know or place unwarranted weight on specific but random numbers.
For example, an investor who buys a stock at £2.05 will often go on to consider a price above that as expensive and below that as cheap, even if the company’s circumstances or wider market conditions have changed substantially.
This can lead to devastating losses when people struggle to correct bad investment decisions, which then compound into even bigger issues in the future.
Similarly, people can often decide to budget 20% of their salary towards their savings & investments, even if that number is totally disconnected from any financial plan and has no relevance to their future objectives. 20% simply sounds like a nice number and a healthy amount to save, which makes people feel good.
8. Misunderstanding Probability – People often think in “absolutes”. Either something will happen, or it won’t.
But that is rarely true in real life. The concept of probability, and the difference between how possible something is versus how likely something is, can be difficult for the average person to fully grasp.
One result of this, is that most investors do not place enough weight on things which carry a low probability of high losses combined with a high probability of moderate long-term returns.
To help visualise this, some economists have referred to “picking up pennies in front of steam rollers”.
The inverse can also be true, given long-term returns go hand in hand with short term volatility – thus, many investors are unconscious to things that carry a low probability of long-term returns or volatility, combined with a high probability of losses. A good example of this would be holding long-term savings in cash – there is a low probability its value will fluctuate around in the short term, but a high probability that it will incur losses over the long-term.
9. The Endowment Effect – People tend to value investments simply because they own them and have an aversion to losing them.
This explains why so many people who inherit assets tend to retain them without making any investment changes, even though they are unlikely to meet their own risk profiles or seamlessly align with their own financial objectives.
Similarly, people might hold on to investments because they have owned them for a long-time and have an emotional attachment to them, rather than because they provide the most appropriate investment option or the best expectations for future returns (this is especially common with people who own shares of their current or former employer).
Emotions like fear, greed, and regret can play a significant role in financial decision-making and can lead to decisions that are not well thought out. For example, fear of losses can lead individuals to sell stocks at the bottom of a market, when they should be buying, while greed can lead individuals to take on excessive risk in the hopes of achieving higher returns.
Behavioural finance has important implications for investors, as it suggests that they need to be aware of their own biases and emotions in order to make well-informed investment decisions and well-informed decisions around money in general.
This requires a level of self-awareness and introspection, as well as an understanding of the ways in which biases and emotions can impact decision-making. Investors can also benefit from seeking the advice of a professional Financial Planner, who can ensure accountability, help investors make well-informed decisions, and avoid costly mistakes.
As always, please do get in touch if you’d like to discuss anything in this article, or if you would like to discuss your own personal circumstances and future objectives with one of our Financial Planners.
By Technical Team @ Abacus
Adam Dalby – Chartered Financial Planner
Kay Pindoria – Financial Planner
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