“Don’t risk what you have to get something you don’t need” — Warren Buffet
Behavioural finance attempts to explain and increase understanding on how human react towards money, investment and how emotional processes influence financial decision. Behavioural finance consists of three important aspects; psychology, sociology and finance. Essentially, behavioural finance attempts to explain the what, why, and how of finance and investing, from a human perspective.
According to behavioural finance, investors tend to take emotional decisions and behave in unpredictable or irrational ways. Behavioural finance also shows that investors systematically make mistakes when investing.
By being aware of these behavioural biases, it is possible to avoid some of the financial decision mistakes. Below are some behavioural concepts that you should understand as an investor:
Confirmation bias
The theory behind confirmation bias explains that we unconsciously tend to disregard or ignore information that goes against our views. We only look for information that confirms our beliefs. Hence, we are biased towards finding information that will confirm our beliefs only.
Our biases tend to limit our ability to make purely rational investment decisions. Whether the investment is bullish or bearish, we need to spend some time studying the views of others with whom we disagree. By doing this we can either strengthen our existing views or understand the potential flaws in our current thinking.
Hence, we always think, all our financial decisions are correct. We as investors should always give space to accept new ideas and opinions to benchmark our current belief at all time. The most successful investors succeed not because they are right all the time, but in fact, exactly the opposite. They invest with a measured approach, balancing risk and return, in anticipation that the market will often deliver outcomes different to what they expect.
Ego depletion
The theory of ego depletion explains that we lose our ability of self-control for a period, when we experience very intense or prolonged mental exhaustion.
In other words, you are not able to completely control your emotions, temptation, impulses and behaviour. Another interesting conflict of ego depletion is motivational conflicts.
This is when, there is a clash between selfish motives (ego) and behaviours that promote social acceptance (motivation). Therefore, when ego is depleted, self-control is hardly possible.
Many research theories argue, although the consequences for emotional self-control are significant, recovery isn’t difficult. Thus, you can recover by following these relatively simple steps; distance yourself from stress inducing financial decisions for a temporary basis and think rationally.
Overconfidence
As human beings, we tend to overestimate our own skills and ability to predict success. Confidence to a certain level is needed in life, if we are not optimistic, we might not develop to next level and accumulate needed wealth. It takes confidence to take risk, plan for the future and defer gratification, but overconfidence often leads us to have an unrealistically positive view on financial decisions.
From my experience, investors also tend to take high risk (uncalculated risk) when they are overconfident, and overconfidence sometimes leads to greed. It’s good to regularly challenge our investment views. When investments go well, you mustn’t get too full of yourself and believe everything you touch will turn to gold. It won’t. I personally learnt this with many investment failures because of overconfidence.
Herd behaviour
Herding is the idea where people feel most comfortable following the crowd and tend to assume the consensus view to be the correct one. Most investors look to see what everyone else is doing, and then follow, getting embroiled into the most overhyped investment instrument.
It can result in massive
bubbles which, when they burst, cost investors badly.
I think most of us still remember the Genneva Gold Investment scam and many forex trading hype which resulted in losses in millions.
Gambler’s fallacy
Humans tend to be overconfident and illogical when predicting random future events. One mistake they make is thinking that past events have a connection to future events.
For example, if someone flips a coin. The odds of the coin coming up heads are 50/50.
Even if the coin comes up heads for five tosses in a row, the odds don’t change. They are still 50/50 for the sixth toss.
But gambler’s fallacy makes people think that the sixth toss will be tails. They think it must be this way because the previous five tosses all came up heads. This is a guess based on intuition, not a certainty based on statistical probabilities.
This bias can be dangerous. Investors shouldn’t make decisions based on the belief that a winning or losing streak “just has to end.”
Instead, they should be basing decisions on data or research. Some people see investing like gambling, but it is not the same as gambling at a casino. In fact, real investors will tell you that there is no gamble involved in investment.
Throughout history, many investors have faced strong temptation to join the investment bandwagon based on emotions, rather than a sound financial planning and strategy.
The unfortunate truth is that incompetence robs investors of the ability to remedy the problem.
Only education has the potential to overcome the related problems of incompetence and overconfidence. Unfortunately, it seems that most investors would rather go through life blissfully ignorant than spend the time to educate themselves on the science of investing.
If you are keen to learn more on behavioural finance I suggest you can start reading any of these three books: Your Money and Your Brain (Author: Jason Zweig), Beyond Greed and Fear: Finance and the Psychology of Investing (Author: Hersh Sefrin) and Why Smart People Make Big Money Mistakes (Author: Gary Belsky and Thomas Gilovich)
I hope this guide has provided you with useful insights on the concepts of behavioural finance. As humans, we are effective decision-makers, but tend to have flaws that can cause problems in the realms of investing.
Understanding what we lack can help us avoid these problems and invest better.
Behavioural finance is one of the important pillars in financial investment that we should emphasise on before embarking on our investing journey.
Gunaseelan Kannan, a licensed financial advisor by Bank Negara Malaysia and a licensed financial planner by Securities Commission (CMSRL/B4198/2013), is currently pursuing his PhD research on financial planning and financial technology. He also lectures on accounting, finance and business fields in Asia Pacific University of Technology and Innovation (APU). He is the Malaysian Financial Planner of the Year 2018 and 2019 Award winner (1st Runner Up), from Financial Planning Association of Malaysia. Email: [email protected]