How understanding behavioural finance could improve your decisions
September 2024
The study of how psychology affects financial behaviours is fascinating. Understanding the basics could improve your relationship with money and how it influences your financial decisions.
Behavioural finance looks at how psychological influences and biases affect the behaviour of investors. It aims to understand why people make certain financial choices and the effect it could have on returns.
The study argues that investors don’t always behave rationally or have self-control. Instead, your mental state and biases play a role in your decision-making.
As well as the effect it has on an individual’s wealth, behavioural finance notes that it could explain market anomalies, such as a sharp rise or fall in the value of a particular stock or even an index.
For example, one behavioural financial concept is the “emotional gap”.
The emotional gap refers to decisions based on extreme emotions. You might read a headline about how a company’s value is going to “plummet” in the newspaper. If you hold stocks with that company, it’s normal to fear or worry about what that could mean for your finances. These emotions might prompt you to sell the stock to avoid the perceived potential losses, even if that decision doesn’t align with your long-term financial plan.
If a large group of people read the same headline and also experienced fear, it could lead to the price of that company’s stock falling, even if its intrinsic value hasn’t changed.
So, how could improving your understanding of behavioural finance help you?
Awareness of behavioural finance may help you keep your emotions in check
It’s normal for your experiences to affect your emotions and decisions. Yet, when you’re investing, it could lead to you making decisions that don’t align with your goals and potentially harm your long-term plans.
Deciding to withdraw investments because you’re worried the value will fall might lead to lost returns when you look at the bigger picture.
It’s not just negative emotions that could influence your investment decisions either. You might also feel excited about an investment opportunity after you’ve read about it in the newspaper, so you proceed without fully assessing the risks or if it’s right for you.
According to an FTAdviser report, 61% of investors who take financial advice worry about short-term market movements. A similar proportion also regularly made decisions or proposals based on these concerns that “surprised” their adviser.
Being aware of financial bias could mean you’re able to keep your emotions in check.
Recognising bias could put you in a better position to evaluate information
Emotions are an important part of behavioural finance, and so is understanding how you evaluate information.
For example, loss aversion is a type of bias where your view is anchored to a particular piece of data. You might hold on to this information, even if it becomes irrelevant or separate data offers a different view.
Let’s say you first see a stock listed for £50. You might become fixated on this price regardless of other factors that may affect its value when you’re deciding how to manage the investment.
Once again, these types of bias could lead to decisions that aren’t right for you.
Understanding investor behaviour could help you feel more confident about market movements
As an investor, it can be challenging to keep your nerves in check when the market is experiencing volatility. Understanding what might be driving this could help to put your mind at ease.
The market moving up and down is part of investing. Numerous factors affect the value of the market and short-term movements are normal. Yet, when you see values fall, it can still be nerve-wracking. It can make it tempting to try and time the market to minimise losses.
However, as investors, and as a result the market, can act irrationally, timing the market consistently is impossible. Rather than reducing potential losses, it could mean you miss out on returns overall. Recognising this may help you feel more confident during periods of volatility so you’re more likely to stick to your long-term investment strategy.
Historical data shows that, despite short-term movements, the long-term trend of markets is an upward one. Even after periods of recession or downturns, the market has recovered when you look at returns over years rather than days or months.
It’s important to keep in mind that investment returns cannot be guaranteed and there is a risk. However, for most investors, taking a long-term approach makes financial sense.
Working with a financial planner could reduce the effect of emotions and bias
Recognising when your emotions or biases are influencing your financial decisions can be difficult. Working with a financial planner means you have someone to turn to when creating your financial plan if you’re thinking about making changes. With the benefit of a different perspective, you can identify when you might be responding to emotions or bias in a way that might harm your long-term goals.
If you’d like to talk to us about your financial plan, please contact us.
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.