Behavioural finance is a relatively new field that combines behavioural and cognitive psychology with conventional economics and finance to explain why people make irrational financial decisions. Many finance and economics experts have tried and failed to explain certain types of investor behaviours. Adding a psychological element to traditional financial theories helps to account for these irrational actions and provides better understanding for how and why people do what they do.
Below are some key concepts of this field which may help to explain why investors make these bad financial decisions and how best to avoid them.
The gambler’s fallacy occurs when people wrongly believe that if an event occurs frequently in the present, it is less likely to occur in the future, or vice versa. For example, when a person tosses a coin and it lands “heads” up for 10 consecutive tosses, they may think that the next toss is more likely to land “tails” up. In fact, every coin toss has the exact same odds (50%) of landing either “heads” or “tails” up. This is a fundamental flaw when understanding probability theories, as past events do not affect future ones.
In investing, some traders are quick to sell their stocks when prices keep rising, thinking it unlikely that their position will continue to increase. On the other hand, there are investors who succumb to the opposite and refuse to sell even when their stock continues to drop. Instead of deciding based on a series of events, investors should look to fundamental and/or technical analysis before making a move.
This concept should not be a surprise to anyone who has ever had a social interaction. Herd behaviour is the tendency for individuals to go along with the actions or a larger group. When separated from the group, however, individuals may not make the same choice. The social pressure of conformity is often the prime reason for herd behaviour by people who want to avoid being labeled as outcasts. The belief that such a large group could be wrong is another reason for such behaviour, which convinces the undecided that the existing course of action is the best one.
A current example of herd behaviour can be seen in the recent cryptocurrency boom. New investors are being drawn into the hype, even though many cryptocurrencies have uncertain use cases and are not backed by tangible assets. Prices are being driven up by irrational demand, which may fall as quickly as they rose. This in turn could hurt a lot of investor portfolios, so caution is advised before engaging in cryptocurrency transactions.
In an ideal world, a person’s ideas and opinions should be based on relevant and accurate facts to be considered valid. Unfortunately, this is not usually the case. The concept of anchoring points out our tendency to attach or “anchor” our thoughts to a reference point even if it is not logical or helpful to the decision at hand. This often happens when people are confronted with concepts that are new, as it provides a false sense of security that they are making a reasonable choice.
Investors that fall prey to this fallacy often base their decisions on irrelevant figures and statistics. If, for example, Company A hit a high of $100/share in 2016 and dropped to $50/share in 2017, some investors may rush to buy this stock as they perceive it to be offered at a “discount”. They are anchoring on a recent high to inform their purchase, but it is also possible that certain fundamental events caused this drop and its price will not recover. Perhaps the company had a scandal, or lost one of its partners. These factors need to be taken into consideration before investors jump on the bandwagon.
Confirmation and Hindsight Biases
As the saying goes, first impressions definitely matter. When we encounter something for the first time, we tend to be selective – we accept the things we agree with and reject those that we don’t. This type of thinking is called the confirmation bias. In the day to day, this can affect our political opinions, stands on certain issues, and how we relate to the world in general.
In investing, this bias can skew an investor’s perception so much that they only look for information that supports the choice that they have made. If said investor has already purchased the stock for Company A, he might only read articles about how this stock is bound to go up instead of also looking into how it may not. To remain as unbiased as possible, investors should be informed on all relevant perspectives.
Hindsight bias tends to happen when someone believes a situation that has already occurred was predictable and obvious, even when the event could not have been reasonably predicted. Sometimes investors think that their trade was successful because they accurately predicted market movements, but it could be that they just got lucky. It is important to keep in mind that there are many factors that contribute to the way a situation turns out.
These four key concepts are only the tip of the iceberg when exploring the field of behavioural finance. Investors continue to be affected by them whenever they are confronted with a choice, and a better understanding of their underlying psychology could prevent them from making costly mistakes.