Behavioural finance: why we can make irrational investment decisions

We often like to think of ourselves as rational beings who make decisions in a logical way, but the reality can be quite different. Behavioural finance, the study of how psychology influences our investment decisions, shows we often behave irrationally and can act against our own best financial interests.

Behavioural finance explores how our emotions, beliefs and biases affect our financial decision-making. By shedding light on some of our irrational habits, it offers insights that can help investors avoid common mental pitfalls and make more informed financial choices.

Behavioural finance can look at human behaviour on an individual level. So it can, for example, examine how someone’s confidence in their own abilities can influence their investment choices. But it can also consider market behaviour, by assessing how psychological phenomena influence large-scale market movements.

One key area of behavioural finance is the study of biases. These can lead us to act on emotion or make errors in processing information. We now examine six of these biases.

Confirmation bias

This is the tendency to favour information that confirms our pre-existing beliefs while discounting evidence that contradicts them. For instance, an investor who believes strongly in a particular company share may seek out only positive news about the company, ignoring any negative reports. Confirmation bias can lead to overconfidence in an investment decision and a failure to recognise potential risks.

Recency bias

Also known as experiential bias, recency bias happens when recent events disproportionately affect an investor’s perception of the future. For example, an investor who experienced significant losses during a market downturn may become overly cautious, believing that another downturn is imminent. They may then avoid investing even when evidence shows that markets or the economy have recovered.

Loss aversion

Caution towards potential losses, when it has the effect of overriding our desire for potential gains, is a bias known as loss aversion. This bias can cause investors to hold on to poorly performing investments for longer than is rational, in the hope of recouping their initial investment. The emotional pain associated with losses can cloud judgement, leading to missed opportunities to reallocate money in more beneficial ways.

Familiarity bias

This bias drives investors to favour investments they already know, such as domestic, locally owned companies or well-known companies in general. While this might feel safer than venturing out into the unknown, it can result in a lack of investment diversification, which can increase a portfolio’s level of risk.

Mental accounting

When we categorise money into different groups and treat it differently as a result we are performing mental accounting. To give an example, an investor might divide their money into daily expenses, a rainy day fund and holiday savings, but splurge on a luxury item after getting a tax refund. This compartmentalised view can lead investors to make poor financial decisions that don’t account for their whole financial situation. Did they really need that luxury purchase and would they have bought it had they viewed their tax refund differently?

Framing

According to modern portfolio theory, an investment should be evaluated based on how it affects the overall portfolio, not in isolation. In practice, though, we often focus closely on individual investments or particular types of investment assets and this ‘narrow’ frame can increase our sensitivity to losses. By adopting a ‘wide’ frame that considers the entire portfolio, we are more likely to accept and manage short-term losses and stay committed to our long-term investment strategy.

Overcoming financial irrationality

Each of these biases is believed to be based on an innate human need to protect ourselves from harm. For example, recency bias stems from our desire to shield ourselves from a repeat of a difficult experience, while familiarity bias can help us avoid diving into risky or unproven investments.

But overreliance on our biases can be counterproductive. It’s important to learn when to listen to our psychological alarm bells, and when to acknowledge that they may be working against our broader financial interests.

At Schroders Personal Wealth, our advisers are skilled in dealing with investor emotions. One of our key principles is to have regular reviews with an adviser. This can help you avoid common investment and financial mistakes and keep focused on your long-term goals.