10 July 2024
Behavioural finance is an interesting topic that differs from traditional finance theories based on facts, figures and fair valuations. This concept first emerged in the late 20th century, with Daniel Kahneman and Amos Tversky at the forefront of coverage. It's essential to appreciate behavioural concepts, as a survey back in 2018 showed that 83% of financial advisers believe that behavioural finance was at the heart of many so-called market anomalies.
There are two main concepts: cognitive bias and emotional influences, which, if many of us are honest, do impact our investment decisions.
These biases are at the heart of human judgement, decision-making and resulting behaviour. When it comes to investment, there are three main cognitive biases to consider:-
As the term suggests, this is a situation in which an investor believes they have more knowledge or predictive abilities than they actually have. It can lead to excessive trading, which will often result in lower returns.
This is an interesting concept, the idea that the first comment or piece of research that we read about a particular investment creates an anchor and the heaviest influence. Overreliance on the first piece of information is best demonstrated in the real estate market, where the initial listing price has a strong anchoring bias.
Very often, we will go looking for information and research that confirms a pre-existing belief within our minds. For example, you may believe a particular stock is worth buying, and you won't stop until you find research or an article that confirms your opinion. Those suffering from confirmation bias will often ignore contrary evidence, leading to poor investment decisions.
This is much simpler than cognitive biases and is a situation where emotional influences, predominantly fear and greed, significantly impact your decision-making process. When it comes to fear, after initially missing out on the purchase of a stock and seeing the price move higher and higher, there is a fear that you will miss out, and you pay over the odds.
Greed is a concept many of us will be familiar with when it comes to investment markets, holding on for that last dollar, that very last tick higher. Very often, when a stock has enjoyed a significant upsurge, once it hits a certain level, it will be susceptible to profit-taking, which can cause a relatively quick downturn. The greed for that last tick upward sees many people losing 5%, 10% and more when the stock turns down, but they hold on, refusing to admit they were wrong.
There is an index known as the Volatility Index (VIX), which measures the short-term volatility of markets. Many believe it reflects investor fear and greed. It is certainly one to watch!
Another element of the behavioural finance concept is major theories which relate to investment and how we react to certain situations.
Often referred to as loss aversion theory, prospect theory says that investors treat the value of gains and losses differently. Typically, an investor presented with two equal opportunities is more likely to be drawn to the one that references potential gains, than potential loses, reflecting the optimistic outlook held by many investors. This is known as loss aversion theory, something worth testing next time you have two options.
This is a fascinating topic: we treat and categorise money differently based on its source and intended use. For example, if you have funds in a pension, you may be drawn to more risky investments than if it was held in your own name, which you would have immediate access to. The amount of funding is the same; you are the ultimate owner, but many people allocate these resources irrationally in a way that does not maximise their financial well-being.
Is trend analysis and herd behaviour two sides of the same coin? The concept of herd analysis is straightforward: it leads to overbought and oversold positions. The power of this behaviour was best demonstrated in the dot-com bubble at the turn of the century. Valuations went out the window, and many investors followed the crowds. The crash was dramatic when the share prices turned down, with little fundamental support.
As investors, the majority of us will have experienced many of the above theories and behaviours when considering where to invest our funds. Those who have never experienced any of the above investment traits are likely in the middle of one as they read this article. Human nature and value analysis are at different ends of the investment spectrum, and it's challenging not to have experienced both in your investment career.
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