Behavioural Finance: What it Tells You About Your Investing Habits
What is Behavioural Finance (BF)? BF is a field of financial economics that proposes psychology-based theories to explain investment habits or stock market anomalies such as bubbles and market crashes. Contrary to the Efficient Market Hypothesis—which assumes that investors are fully rational individuals who are all equally able to properly process complete and reliable information and act accordingly—BF’s foundation is that investors are subject to several biases so that their financial decisions are far from being fully rational.
Here are BF findings that can impact investors’ trading decisions.
Some investors have second thoughts that cause them to delay an investment without any rational arguments, just because of the fear of taking a risk. When the investment opportunity is lost, they regret undergoing inertia and often grow even more insecure regarding their investment decisions. For example, an investor does a detailed analysis prior to rebalancing her portfolio, but decides not to proceed because of the fear of not having taken everything into account.
Similar to Inertia, Anchoring is a cognitive bias which involves decision making based on an initial anchor (or prior belief) that people have difficulty changing even if new counter evidence shows up. For instance, some traders tend to “fall in love” with a trade they did some time ago even if the initial conditions that justified it are now gone. “I will never let go of this stock no matter what, I just can’t” is a classic quote of investors suffering from Anchoring who hold-on to past beliefs rather than adapting their decisions to the new reality.
Linked to Loss Aversion, it is the tendency to deny a bad decision and assume its consequences. This bias is often found in investors who drag along bad investments—hoping they will rebound someday—rather than taking the hit (“cementing” a loss) and moving capital to better investment opportunities.
Many investors are overwhelmingly influenced by recent events. Incorporating recent information is part of a good investment or trading decision process. However, for long-term investors, new information on a relatively minor issue is sometimes given too much importance relative to the bigger picture about the company. For example, a slight decline in the price of a stock due to the bad behaviour of one of the company’s executives may wrongfully be seen as a major selling signal even if the company is solid and on a steady growth path.
Some investors have an exaggerated view of their own abilities to make great investment decisions which may lead them to take unwarranted risks leading to a weak or an erratic trading/investment performance. Overconfident investors may also believe that they exercise some control over their investments… which is very rarely the case. A typical overconfident trader may decide to buy a stock just because he is sure that the new design of a product will be a hit… without actually knowing anything about the product’s market or its buyers’ profile.
Some investors may make decisions based on information that is not pertinent. For instance, one may have the tendency to invest in a stock following the inauguration of a new head-office, as the flashy building is wrongly interpreted as representative of the strength of the firm’s growth opportunities.
Most individuals allocate their wealth across different mental “compartments”. Goal-Based Investing (GBI) is an example of Mental Accounting: people save to reach a financial goal, like buying a cottage in 10 years. GBI is a very good investment approach, but it requires a proper portfolio construction process to be successful. Mental Accounting without having the big picture in mind can lead to an ill-diversified portfolio, which is bad for an investor.
Last but not least, Herding is one of the best-known BF findings. It covers a wide range of investment habits and market anomalies, such as financial bubbles. Individuals feel the need to join in groups (herds) and, consequently, develop herd behaviour in their decision making. Said otherwise, some investors instinctively copy what they think the majority of investors are doing, rather than relying on their own assessment of facts or taking into account their own situation. You probably recently heard someone say, “Everyone is investing in this company; I should join the crowd. If I don’t, I will be the only one that will have missed an opportunity everyone else spotted.” Well… we now know how dangerous this kind of reasoning is… especially if you are late to “join the club”.
Every investor has his own mix of cognitive and psychological biases. It is good that you keep them in mind and try assessing to what extent they are present when you are about to make an investment or trading decision. As Cicero famously said: “Suum quisque noscat ingenium” [Let each one know his own mind.].
Pierre Laroche and Mathieu Leblanc
Edited on 17 July 2018