In finance and economics, leading thinkers have tried to explain the underpinnings of our money decisions, attempting to understand why we do what we do.
Traditional economic theories were used to explain and predict market behaviour in the past. Older schools of thought described previous behaviour to create models for the future, but such models could have been more extensive.
When we think about finance and markets, we imagine mathematical models and perfectly rational behaviour. But the real world rarely reflects such things. Some economic theories need to fully account for the complexity of human psychology and behaviour when making financial decisions. A boom in evidence over past decades demonstrates that financial decision-making at all economic levels usually departs from rational information-processing models’ predictions, rendering them inaccurate.
The gaps in understanding and prediction led to the development of behavioural finance. This field integrates neuroscience and psychological insights into economic theory. Data from various sources, including studies of the human brain, online trading activities, corporate communications, and genetics, has led to the discovery of new cognitive processes that influence financial decisions.
The modern classic “The Psychology of Money” by Morgan Housel has further intrigued people into studying behavioural finance, explaining the mechanisms behind wealth and greed.
Here, we explore its foundations, history, and importance in today’s economic environment. Moreover, we delve into the common cognitive biases it addresses and recommend strategies for better decision-making.
Understanding the Psychology of Money
Financial decisions shape our lives and are among our most important choices. They determine our present and future well-being. Because some households lack financial literacy, they may violate sound economic principles. Examples of common mistakes include over-diversified stock holdings and low retirement savings rates.
It isn’t just typical households that make mistakes. Driven by emotion and cognitive biases, some investors trade too often and extrapolate too much from past returns. C-level executives are not immune to money mistakes despite their academic backgrounds. Errors at this level may stem from overconfidence and personal history.
We can better understand the reasons for such financial errors by learning about money’s psychological basis.
What is behavioural finance?
Behavioural finance is a behavioural economics subset. It studies the influence of psychological and neurological factors on the behaviour of individuals, including investors and financial analysts, and the subsequent effects of psychological factors on the markets.
This school of thought focuses on the principle that human beings—and thus investors—are not always rational. We are limited by our biases and degree of self-control.
The roots of behavioural finance go back to the 1970s. It was founded on the work of eminent psychologists Amos Tversky and Daniel Kahneman. They were among the first to openly challenge the notion that economic decision-making was rational and explored the influence of cognitive biases on human behaviour.
From this foundation, economists Robert Shiller and Richard Thaler developed the field. They demonstrated how biases impact investment decisions and financial markets.
On the irrationality of markets, Kahneman once wrote that one of the significant differences between behavioural and standard economics is how they explain motivation. In standard economics, individuals are supposedly driven by the utility of future wealth.
On the other hand, behavioural economics stipulates that agents are motivated by gains and losses, relating to primitive instincts for pleasure and pain.
Behavioural finance vs. traditional financial theory
To understand the perspective of behavioural finance, we need to grasp the foundations of traditional financial theory. Traditional finance believes that both investors and the market are perfectly rational. It also assumes that investors care about utilitarian characteristics.
Moreover, it assumes investors have perfect self-control and are not vulnerable to information processing or cognitive errors.
By contrast, behavioural finance recognises that humans are not always rational and often make decisions based on emotions, biases, and heuristics. Thus, it differs from traditional finance in several vital ways.
It presumes that emotions and irrational behaviour primarily drive markets. While conventional finance heavily relies on statistical analysis and mathematical models, behavioural finance integrates psychology and sociology to better understand market dynamics.
Common Psychological Biases in Money Management
Cognitive bias makes up an essential pillar of behavioural finance. Awareness of such biases is a shortcut to becoming a more savvy investor and financial manager, enabling people to avoid systematic errors in judgment. Common examples of cognitive bias include:
Overconfidence Bias
Some people overestimate their abilities and knowledge. Overconfidence may lead to increased risk-taking, which can be harmful, especially if they don’t know how to cover their risk.
“Overconfidence can be a silent portfolio killer. Many investors overestimate aptitude for predicting market movements, leading to risky bets and insufficient diversification. Recognising this bias and following a diversified, passive investment strategy, or learning from financial experts if you want to be an active investor, can help create a more balanced and resilient investment strategy,” says Mike Wallace, CEO of Greenback Expat Tax Services.
Talking about your ideas with a professional helps avoid hasty investing decisions, including attempting to time unpredictable markets. Moreover, it enables you to go through the pitfalls of your decision, including any resulting tax implications.
Loss Aversion
People are afraid of losing money. This fear often leads individuals to make conservative investment choices, even against their best interest. Loss aversion can cause overly cautious investors to miss out on crucial opportunities.
For example, someone who loses $1000 on an investment will feel twice the pain compared to the pleasure of gaining the same $1000 on a correct trade. A person is less likely to buy a stock if the risk is higher despite the high reward. Loss aversion notably grows stronger as the stakes grow higher.
This form of cognitive bias can pose a problem in the long term. Investors who only favour low-risk, low-return investments will need to grow their money more to achieve their retirement goals. One way to avoid this bias is by holding on to your portfolio or not selling when the market is down. You are only truly “lost” when you’ve sold now—unrealised loss. Talk to a professional to get a better understanding of your options.
Herd Mentality
The crowd is a powerful influencer of individual behaviour. People tend to follow the majority owing to a deep-seated tendency for mimicry. However, the herd mentality eventually leads to irrational behaviour and market bubbles. The crowd must often be corrected, and wild trends are usually short-lived.
The repercussions of crowd behaviour can be costly. Historical examples include the 2001 internet stocks bubble or the meme stocks of 2021.
While it makes sense to consider that there is safety in numbers, investing is a different field. Because every person’s situation is personal and unique, jumping on a bandwagon tends to obliterate this personalisation.
Review your current financial situation and strategy. Remind yourself of your unique path to reaching your goals. After thinking it through, you may find the impulse to follow the crowd less appealing than you initially thought.
Anchoring Bias
People can latch on to the first piece of information they receive. This initial bias can anchor them to a particular way of thinking that influences their future decisions, even if the anchoring thought is irrelevant or misleading.
Anchoring bias can also be defined as the slow reaction to the market, corporate, or economic developments due to an illogical or emotional attachment to a perceived value, which can happen even in the face of changing information.
There are many examples of anchoring bias in the investing world. Individuals create anchors based on news, conversations with peers or colleagues, and social media feeds. Anchors can become a problem when they have no bearing on future decisions.
For example, the decision to buy a fund at a given price depends on the individual’s financial situation, the prospects of the instrument, and the fund’s strategy. It has nothing to do with the price your friends bought it at.
To avoid making this error, you can go through an exercise. Consider the source of the recommendation. Is this person in a financial circumstance similar to yours? Are you buying the financial product at a similar timing and valuation? Would the choice align with your financial goals? These questions will help you make a more rational and informed decision.
Mental Accounting
Some people tend to compartmentalise their finances. As a result, they treat different types of money differently, missing the complete picture. This type of compartmentalisation, called “mental accounting,” may lead to suboptimal decision-making.
Confirmation bias
Confirmation bias is the flawed tendency to look for information that supports or confirms our beliefs, rejecting information contrary to our thinking or beliefs. This bias can manifest as clicking only on positive headlines that help your stock-buying decision and avoiding the negative ones.
Confirmation bias can become problematic because it limits the information you absorb, leading to missed warning signs. You can avoid confirmation bias by consciously challenging yourself to include differing perspectives when researching a product or investment decision.
Leverage Behavioural Finance for Investing Success
Financial decisions heavily influence people’s lives. These decisions operate at many levels of the economy, from the household level to corporate decisions and government policy.
Their cumulative effect further impacts the population’s financial well-being. Many historical examples, such as the 2008 financial crisis or the Great Recession, point to the systemic impact of gullibility and cognitive biases.
Being sensitive to psychology and thinking at all levels, we must understand how the financial ecosystem operates. Furthermore, we can use the insights we gather to improve our choices. Awareness of the behavioural finance model helps us avoid the pitfalls of common biases in thinking. We can use history and behavioural finance lessons to optimise our financial behaviour.
To circumvent the inherent biases in our behaviour, we can employ automated tools to systematise our savings and investment plans and develop low-cost nudges to remind us of payment responsibilities. We can also work around our suboptimal habits by building a diversified investing portfolio, which helps manage risk and emotional volatility.
Seeking professional financial advice helps ensure we’re on the right track. A qualified financial advisor provides you with specialised knowledge, preventing uninformed decisions. Employing the proper assistance and tools to eliminate cognitive biases increases the odds of investing success.
