As people make investment decisions which will naturally vary in terms of performance, and these decisions affect an investors financial future, investing can become an emotional ride for many. Behavioural finance is the study of the effects of psychology on investors and financial markets. It focuses on explaining why investors often appear to lack self-control, act against their own best interest and make decisions based on personal biases instead of facts. Understanding the theory helps us to see how irrational, biased and emotional investors move the markets. Some of the most common cognitive biases in the investment world include:
Anchoring – This describes the subconscious use of irrelevant information, such as the purchase price of a security, as a fixed reference point, commonly referred to as an anchor, for making subsequent decisions about that security. The original purchase price would then carry a disproportionally high weight in a persons decision making process. In the context of investing, one consequence of anchoring is that market participants with an anchoring bias tend to hold investments that have lost value because they have anchored in their fair value estimate to the original price paid, rather than to fundamentals. As a result, an investor may take on greater risk by holding onto an investment in the hope that the security will return to its purchase price.
Framing – This bias occurs when people make a decision based on the way the information is presented, as opposed to just on the facts themselves. The same facts presented in two different ways can lead to people making different judgements or decisions. For example, if an investment was marketed as having a 20% chance of making a gain, people would generally be more interested in it than an investment with an 80% chance of making a loss, even though they are the same product. This has important implications for the marketing of investment material and it is important for investors to use a logical, reflecting approach to decision making and avoid impulsive, reflexive decisions.
Confirmation bias – This is a term that describes how people naturally favour information that confirms their pre-existing beliefs. The principle applies to investors in notable ways. Investors generally seek out information that confirms their existing opinions and ignore facts or data that contradicts them. This can skew the value of their decisions based on their own cognitive biases. Human beings have the tendency to actively search for, interpret, and retain information that matches their perceived notions and beliefs. Therefore if an investor has purchased a security, it is likely that they will seek out information that confirms they made the correct decision to make the purchase. It is an important bias for investors to be aware of as it can help overcome, poor decision-making, missing chances and avoid falling for bubbles.
Loss aversion – This is a phenomenon in behavioural economics which finds people view a real or potential loss as psychologically or emotionally more severe than an equivalent gain. For example, the pain of losing £100 is often far greater than the joy of an equivalent sized gain. Furthermore, the psychological effects of experiencing a loss or even facing the possibility of a loss, might even induce risk-taking behaviour that could make realised losses even more likely or more severe. The consequences of this bias is that an overwhelming fear of a loss can cause investors to behave irrationally and make bad decisions, such as holding onto a loosing stock for too long, or selling a winning stock too soon. A common error is for an investor to make the mistake of hoping a stock will bounce back, against all evidence to the contrary, because losses lead to more extreme emotional responses than gains.
Overconfidence – This bias occurs when investors hold a false and misleading assessment of their own skills or talent. A large number of investors consider themselves to be above average in terms of their investment skill, although it is statistically impossible for the majority of investors to be above the average investor. Overconfidence can lead to mistakes in investing and make investors less than appropriately cautious in their investment decisions. Many of these mistakes stem from an illusion of knowledge and an illusion of control. It can lead many investors to believe they can try to time the market, despite the high rate of failure for those who try, and often leads to underperformance.
Hindsight Bias – This bias allows people to convince themselves after an event that they accurately predicted it before it happened. It can lead people to conclude that they can accurately predict other events and is a common failing of individual investors. Hindsight bias may manifest as a sense of frustration or regret at not having acted in advance of an event that moves the market. It leads to people believing their judgement is better than it is. Once we know the outcome, it is much easier to construct a plausible explanation. With this, we become less critical of our decisions, which leads to poor decision making in the future.