Behavioural finance seeks to highlight our irrational behaviour around investments, money and savings. It draws on a number of disciplines, including psychology. We thought it may be useful to pull together a toolbox for you covering the basic concepts – use liberally to help make better reasoned and more reasonable financial decisions.
What is behavioural finance?
Behavioural finance’s starting point is to challenge traditional economic theory that assumes that individuals are perfectly rational. In fact, it claims that we are not fully rational beings capable of objectively assessing all aspects in play in order to arrive at the decision that is in our best interests.
Behavioural finance takes account of psychological influences on the behaviour of investors or financial analysts. It provides an explanation for errors of judgement in financial decision-taking and market anomalies, via a checklist that enables each of us to become better acquainted with our faults, emotions and cognitive bias. The stated aim is to help you take a more rational approach to finance, which will be beneficial for your wallet.
The four disruptive factors that can spoil everything
Behavioural finance identifies four categories of concepts that may lead us to make mistakes when taking decisions.
Cognitive bias. Cognitive bias is a sort of subjective reality that often appears in the form of a system of misleading thinking based on false logic that comes into play spontaneously when we are called upon to make a decision. Cognitive bias influences our choices, especially when there is a large amount of important information to process, or when time is limited. Such situations can result in false reasoning, which may feel like intuition, but which we should be wary of.
Heuristic simplification. Heuristics are mental shortcuts enabling people to solve problems and make judgements quickly and, seemingly, efficiently. These strategies shorten the time required for decisions based on the association of familiar elements of information in our memory and environment. Whilst heuristics are useful in many situations, they can also lead to cognitive bias. Ignoring objective analysis means that you leave yourself open to the risk of errors when processing information.
Emotions. Intense emotions such as fear or enthusiasm tend to hold greater sway than objective reasoning and can be very bad investment advisers. This is particularly true when they result in overreaction and impulsive decision-making.
Social norms. We are social animals, and generally, we don’t like to go against the flow. Whilst it is reasonable to be influenced by the behaviour of our peers, blind trust in the instinct of the herd can cause us to make errors.
It is difficult to be aware of all the factors influencing our financial decisions. And knowing how to identify them does not guarantee that we won’t fall victim to them. So before we present a number of key concepts of behavioural finance to you, we must emphasise that support from the knowledge and objectivity of a financial expert is extremely useful when taking financial decisions.
There can be no doubt that loss aversion is the most important driver of human decision-making. It is a legacy from our ancestors, whose survival depended on their ability not to waste their scarce resources. The most primitive part of our brain has retained this instinct and adapted it to modern life. This means that we take a different approach to risk, depending on whether we perceive it as a risk of gain or of loss. Research has shown that the pain felt by investors on a loss is over twice as high as the pleasure of making a profit of a similar level. Losing EUR 100 affects us twice as much as gaining the same amount.
In the context of investing, this may translate into holding onto a share even though it is continually falling in value. Why? Because until the loss is crystallised or real, the brain has the illusion that there is no loss and this therefore postpones a form of suffering. Paradoxically, loss aversion may also result in us taking more risks over the long term than we would really wish.
Confirmation bias is the tendency to accord greater importance to information that confirms our beliefs and to ignore anything that contradicts them. Rather than confronting our opinions with opposing facts, we prefer things that validate our views, as this gives us a feeling of well-being and self-worth. This bias feeds our prejudices and limits our ability to take rational investment decisions.
You might be so determined to be right about how to invest your savings that, without even realising it, you only consider information that confirms what you thought before in order to build a simple narrative that your brain can absorb without effort. The upshot of this is that you substitute the complex reality of investing with an utterly biased mental illusion that backs up the decisions you had already made. This should be avoided at all costs.
Overconfidence bias is our tendency to overestimate our abilities. This may lead an individual to believe that they are a much better driver than the average, despite a few failings such as reading texts whilst driving.
When investing, overconfidence bias often leads people to overestimate their understanding of financial markets or certain investments, and to ignore information provided by experts. Overconfidence may therefore lead you to overestimate your risk tolerance and to adopt investment strategies that are not properly suited to your investor profile.
Status quo bias
Status quo bias describes our preference for maintaining the current state of affairs. It translates into a certain resistance to change. Status quo bias is comfortable because it makes decision-making easy, particularly when we don’t know what to do or feel overwhelmed by the numerous options presented to us.
Public policies and some commercial brands have fully understood this when setting default options, for example, when selecting the core components of service subscriptions. Careful attention should always be paid to these default options, and this holds true in the field of investments. Making the cognitive effort to consider or even to opt for change allows us to make the choices that are best for us when we take financial decisions. Even if we ultimately choose the status quo, it will be an informed choice.
In behavioural finance, giving too much weight to what we see as an immediate necessity is called present bias. This bias prevents us from clearly and objectively assessing our actual long-term needs, making us prefer immediate rewards.
Present bias means that we find it hard to resist the temptation of immediate gain, so we tend to prefer short-term financial benefits at the expense of long-term savings intentions. It is also at the root of our tendency to procrastinate, and makes some of us repeatedly put off until tomorrow what we could do today.
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Publié le 24 juin 2021