What is behavioural finance?
Following on from my recent blog “Habits of Successful Investors“, I believe that Behavioural finance is the study of the psychology that affects financial decision-making. In most situations, emotions play a role in investment decisions.
Often, the focus here is on greed or fear, commonly found in investing. Yet, it is not just the emotions of the markets ‘investors that must be considered. The emotions and psychological impact affecting every day financial decisions needs to be considered as well.
In behavioural finance, the focus is on understanding why and how emotions play a role in decision-making so that changes can be made to influence financial decisions in one direction or another.
Are you biased?
Biases are present in virtually all financial decision-making. In fact, this has been documented in study after study. These decision-making behaviours affect all types of decisions a person makes, including those related to money and investing. The biases people have relate to how they process important information to reach the ultimate decisions and preferences they make.
Let’s look a little deeper at biases.
Biases are very deep psychological roots within the psyche. In some situations, they provide a foundation for decision-making. Knowing right from wrong, for example, may be based on fundamental thoughts that can stand anyone in good stead. However, when it comes to investment strategies, biases are not helpful and often lead to mistakes or poor decisions. Yet, they are a part of human nature and are present in all investors. So, what can you do about them?
You can understand them so that you can make better decisions by having this information on hand. It is then possible to reduce their influence and work around them to ensure the ultimate financial decision is based on concrete facts and figures.
Understanding behavioural finance
Take a closer look at some of the biases people have and how to correct them so that you can, ultimately, make the right financial decisions.
- Overconfidence: This is one of the most common biases that leads to bad decisions. Studies have found that most people have unwarranted confidence in their decision-making. You believe you can make better decisions than others. Most people view the world in positive terms. In a financial sense, overconfidence leads to making overestimated decisions in the area of identifying winning investments. It is an issue of control. You believe you have more control over your investments than you really do.
- Loss aversion: Who wants to lose money? The attitudes people have towards risks and reward are also key components to financial behaviour. Risk tolerance estimates often are a driving force in the decisions that investors make. What this means is that people will make financial decisions with the goal of avoiding a loss because a loss has twice the impact on a person’s life as a gain.
- Managing diversification: It is important to create diversification within a portfolio. However, research in the behavioural sciences in this area shows that investors struggle to apply the concept. Often times, naive rules are used to make diversification decisions. In other cases, people invest in what is familiar because it feels safer.
What does all of this mean for you?
Often it means that people are making decisions about their financial futures and investments based on the wrong information. Instead of making decisions based solely on facts and figures, your emotions get in the way. You don’t want to do the homework, so to speak, to determine which is the ultimate best decision based on facts. There are all of these underlying biases that you probably do not realise are there that play a role in your decision-making.
What can you do about it?
Work with an independent financial adviser instead of relying solely on your own gut feelings or needs. It is often best to have more information that is figure-based rather than information based on thoughts and feelings. It is complex to make decisions without factoring in behavioural impact. However, having expert input from a third party, such as that from a professional adviser, can be one way to minimise the risks that stem from financial behaviour decision-making.
Blog posted by Mike Coady.