Behavioural Finance is an academic field with real life implications and lessons to take away – both for everyday life as well as for market and property investments. The founding fathers of the field – Richard Thaler, Daniel Kahneman and Amos Tversky – had backgrounds in Economics, Behavioural Psychology and Cognitive Psychology, and so the theories associated with it are seen as a better representation of actual human behaviour than other economic theories. The explanation for irrational behaviour lies with behavioural biases – beliefs and behaviours which prevent a person from acting rationally. Below is a brief introduction to Behavioural Finance and an overview of five common biases, as well as tips on how to avoid them.
Prior to the emergence of Behavioural Economics and Finance in the 1970s, the dominant theory used for explaining and predicting market and consumer behaviour was homo economicus, which assumes that investors analyse all the available information, undertake risk assessment and compare the investment they are considering with others and will choose the one that appears to be most profitable. Reality tells us that this is far from always the case though. For example – if everybody behaved in a completely rational manner at all times, overvaluations and bubbles would not occur since investors would stay away from stocks of companies that they were unable to analyse fully and not buy or sell simply because other investors and traders were.
Herding Mentality
In the case above, with investors following the flow, the bias at play is herding mentality. A common example from outside the world of finance is the one of two restaurants – one almost full, with just one free table, and the other completely empty. Observations and psychological experiments show that the majority would choose the full restaurant over the empty one and not ask questions such as when the restaurants opened – the one that is empty might have opened within the last ten minutes and the other an hour ago – which may explain why one of them has more patrons. Following the lead of others is normal and does not have to be avoided at all times, but it is important to be aware of herding mentality and ensure that your decisions are your own.
Anchoring
An anchor is the first point of reference that an investor or consumer compares subsequent prices to. In finance, this means using the price a share had when the investor first came across it as the benchmark although this is unlikely to tell them anything about the company’s intrinsic value or qualities. When no other information than a price is available, it is easy to resort to anchoring. Another example can occur when a consumer is presented with an abnormally cheap or expensive product immediately after having seen another product with an even more extreme price. Under normal circumstances, most consumers would consider a 20-euro pencil to be significantly overpriced, but if another pencil in the shop’s display cabinet was priced at 80 euros, the 20-euro piece would appear to be less of a bad deal. Use a correct reference point, and anchoring can be avoided.
Complaisance or Self-Preservation
Attributing success to your skilfulness and failure to bad luck is normal to a certain degree but if you are unaware of it and allow it to spiral out of control it can lead to poor awareness of your abilities and make it difficult to avert problems in the future or repeat successes. Examples include investors putting their successful trading down to skill without considering that they are in the middle of a bull market and, by the same token, attributing financial losses to a bear market rather than any failings on their own behalf. A typical non-finance example is from the world of sports, where an athlete attributes victory to hard practice, and a loss to adverse weather conditions, an incompetent referee or foul play. Luckily, self-preservation bias can be avoided by keeping a consistent record or the decision-making process behind every financial choice.
Status Quo
Many humans are prone to favouring the status quo and shy away from any significant changes. This bias is related to risk aversion. An example from outside of finance includes choosing the same dish and drink from the menu due to not being willing to risk ordering something that one does not like. In finance, it is common for an heir to choose to stick with their relative’s portfolio rather than investing the capital differently – a bad decision given that the portfolio may have been created decades ago when the market looked very different compared with today.
Confirmation
The final bias, confirmation bias, can display itself within any area of life as people tend to seek out or favour information that supports their existing views rather than accurate information. One example includes news outlets – most people read newspapers and websites whose political views they share – and one from finance and business includes the setup of teams, where a manager may choose people whose views are similar to his or her own. While this may reduce friction and create a pleasant workspace, there is the risk that the team ends up as one of “yes” (wo)men as everyone thinks along the same lines. A way to avoid this scenario is to actively seek out information and people whose views differ from yours to minimise the risk of falling in the confirmation trap.