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Why behavioural finance says investing is 80% psychological

Friday, March 18, 2022

Written By

Why behavioural finance says investing is 80% psychological Paddy O'Brien
Why behavioural finance says investing is 80% psychological

Financial Advice | Financial Planning | Investing | Portfolio

"The most contrarian thing of all is not to oppose the crowd but to think for yourself."

WRITTEN BY Peter Thiel

Now more than ever, it’s important to rise above emotions and separate your decision-making from turbulent times.

Maintaining discipline and a level-head goes a long way, and lessons from behavioural finance can prove incredibly insightful. To begin with, there is one question to be asked…

Are financial decisions made rationally?

Traditional economic theory suggests that people and markets are rational. It assumes that humans are rational decision-makers, meaning their investment and financial decisions are rational and markets are efficient.

But in the late 1960s, a new sub-field of psychology countered this ‘rational-efficient market’ belief by focusing on the biases and emotions that influence decision-making.  

Since then, leading academics from the field have won Nobel Prizes in Economics and institutions such as Credit Suisse and Schwab Asset Management have factored behavioural finance into their investment approach.

All the while, behavioural finance has stayed focused on one goal – avoiding financial pitfalls that are underpinned by investor psychology.

Published in 1979 by Amos Tversky and Daniel Kahneman, Prospect Theory was the precursor to Behavioural Finance. The theory introduced the concept of loss aversion, which observed the way that people have different reactions between potential losses and potential gains – even if they are the same value. For example, losing $1000 inflicts a deeper emotional reaction than gaining $1000 would.

As a result, people make investment decisions by trying to avoid loss (or rather the emotion that loss brings) as opposed to pragmatically weighing up pros and cons. To show this, Prospect Theory poses a question...

Given the choice between a 5% chance of losing $100,000, or a 100% chance of losing $5000, which do you choose? From a fear of loss, most people would choose a 100% chance of losing $5000 – even though the first option still gives you a 95% chance of keeping $100,000.

Or another one – given the choice between a 95% chance of losing $100,000 or a 100% chance of losing $95,499, which do you choose? In the hope of avoiding loss, most people would deny rationality and become more risk seeing, choosing the 95% chance of losing $100,000.

But why?

Prospect Theory did what no other economic assumption did before – it considered the behaviour of people and their emotional influence on decision-making. Doing so consequently proved that people are not the rational agents that economics would otherwise believe; and once these findings were published, behavioural finance unravelled all sorts of biases that exist in markets and economies.

Are you biased?  

The assumption is that understanding our biases puts us in a better position to make rational decisions. Like many things, the danger isn’t the bias itself; the danger is not facing it.  

Biases are the irrational or emotional motivators behind decision-making, which often go against rational thought.

In our mass information world, a familiar bias to us is confirmation bias, which is where an individual only seeks out information that supports their opinion and perpetuates the belief that their opinion is right.

But behavioural finance spotlights other, more subtle, biases.

Framing bias refers to the way decisions are influenced by the way that information is presented to us (think about the above probability choice – if the question was framed as a 95% chance of keeping $10,000, rather than a 5% chance of losing $10,000, would that have changed your reaction?).

Availability bias shows that the frequency with which we see information influences our decision making (think about the frequency that Bitcoin is seen in the news or social media, and how that would influence a person to invest in it).

Hindsight bias refers to the tendency to think we knew all along what was going to happen, meaning we never reflect on or analyse our decision-making processes and learn from it (think of that person who “saw it coming” or “always knew” the market was going to fall.).  

In fact, according to behavioural finance, investment is 80% psychology. From why we choose the investments we do, to the points that we decide to buy or sell, our decisions are not always led by rationality – and understanding this allows us to take on a wider, more informed, perspective of the markets that reads between the lines.

Bias in Practice

Market Volatility has taken on a new definition in recent times. We have seen significant global uncertainty, paired with the correlated market panic, and, as technology makes information widely available, our awareness of market volatility seems never-ending.

But to what extent do economic factors contribute to market volatility… and to what extent is it behaviour?

Taking the COVID-19 Pandemic as an example, research studying market volatility from this time showed that panic caused by news outlets were associated with increasing volatility. Even more, research on market efficiency during the same time showed that fear was a bigger motivator for market behaviour than economic predictors were.

That is not to say that economic factors don’t contribute to market trends – but more to reinstate that investment behaviour exacerbates market activity, often irrationally.  

Overcoming Bias

Behavioural finance shows us that there is nothing wrong with facing biases and emotions if you have the strength to confront them and always go back to the facts. After all, behavioural finance teaches us that people are irrational.

Overcoming bias, therefore, starts with acknowledging biases. 

For instance, acknowledging that everyone has a level of confirmation bias gives you a deeper and broader understanding of ideas, therefore putting you in a better position to weigh up all the available information.

But there are also practical ways of keeping yourself in check.

One place to start can be your financial plan. Traditionally, as you put your strategy together, you ‘rationally’ decide how you imagine your future to look like - and in times where you feel nervous or confused, stay focused on that goal. Furthermore, having secure, qualified advice will also help you achieve the same.

You can also stay on track by focusing on why you are investing.

For instance, if your investment strategy is long-term, then stay focused on the long-term goal. In these times of rising global tension, on the backbone of a pandemic, it is easy to lose sight of that. But historical information (from both World War I and II) show that the market always returns to a state of growth.

In fact, taken together, through two of the worst wars in modern history, the U.S. stock market rose a combined 115%.

You can also overcome biases is by using known biases in your favour. We know that people are impacted more by loss than gain so remember that you are investing to avoid the effects of inflation or to stay above difficulties through time.

Critical thinking, an open mind, and a brave face through trying times will make all the difference.

In the end, understanding your emotions puts you in a better position to understand your decisions – which puts you in a better place to control your emotions.

See how our investment philosophy cuts through the noise and stays focused on what matters.

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