Behavioural Finance Biases

What is Behavioural Finance Bias?

Behavioural influence is the study of the influence of psychology on investor behavior. It includes subsequent effects on the markets and focuses on the fact that investors are not always rational, have limits to their self-control, and are influenced by their own biases. Behavioural finance biases are of concern as they influence our judgement about how we spend our money and invest. The most common pitfalls of behavioural financial bias are:  factors like mental accounting errors, loss aversion, overconfidence, anchoring and herd behavior.

More specifically, behavioural finance biases are untrue preconceived notions regarding current or potential investments that can quite seriously limit your investing success. It’s not easy to recognise you have such biases and changing your beliefs can be a challenging task.  However, it’s worth the time and effort to learn to put your biases aside when making important investing decisions. Understanding biases can help you overcome them and make better financial decisions. This way your investment choices can be based on effective research and in depth understanding of the true risk of the investment.

Biases that can affect your relationship with money and what you can do to overcome them:

1. Mental accounting This is when people treat money differently depending on its source and use. We guard some money cautiously when we mentally categorise it but spend it liberally when it’s fun money. This is why most people are more inclined to spend windfall gains on luxury items but would save the same amount if they’d earned it. This can sometimes hurt your bottom line. For instance, if money is in an account designated for education you may choose not to withdraw it to pay off a credit card or personal loan. This can mean you pay higher interest on bills which you could otherwise be used to rebuild the fund or invest. To overcome this, create a budget and an emergency fund.

2. Loss Aversion This is a bias toward avoiding losses over seeking gains. It can cost money as one key financial mistake people make is to take too little risk. Loss aversion explains this as:  losses hurt more than gains are savoured. This can cause people to avoid small risks even when they’re worth it. Those who prefer low-risk, low-reward do so because they fear the volatility of the stock market. To avoid this, try to reduce your emotional attachment, create an investing strategy and make an effort to adopt some risk, even if it’s minimal.

3. Overconfidence bias This is the tendency to view ourselves as better than we are. This is common in investing and overconfident investors generally do not manage and control risk properly. This can make an investor overestimate their abilities and knowledge, which can lead to rash and poor decisions. This often occurs when someone believes they can accurately time the market even though the market is notoriously unpredictable. To overcome this bias, consider using passive investing as active traders tend to do worse than those that buy and hold.

4. Anchoring bias This is a phenomenon where someone overvalues a piece of information to the detriment of subsequent judgements. This can influence decision-making, such as when to sell or when to buy an apartment. Since these investment decisions require multiple, complex judgements, they can definitely be affected by anchoring bias. An example of this is when a person holds onto a stock longer than necessary because they’re “anchored” on the higher price they bought it at. In this way, the buying price biases judgements about the stock’s true value. To overcome this bias, do research and make your decision. A full assessment of an asset’s price helps reduce anchoring bias as does the ability to be open to new information even if it isn’t what you initially learned.

5. Herd behavior bias This happens when investors follow others rather than making their own independent decisions based on financial data. For example, if all your friends are investing in bitcoin you might start too even though you know it’s risky. People follow others because it feels safer. There is also the fear of missing out; if your friends are making money, it can feel uncomfortable to not join in.  However, it is important to be skeptical of products promoted on internet forums because they may not follow legal and government regulations.

Removing behavioral finance biases is something that should be undertaken by nearly all investors.The quality of your investments is directly correlated with the quality of your decision-making. Your biases simply reduce the quality of your decision-making and negatively impact your investment outcomes.

Take the time to learn more about your behavioral finance biases and monitor your approach to your investments. Develop a plan that allows you to work around your natural tendencies. These tendencies are simply a result of human nature so you can change your approach if necessary. This may involve making a new routine that will reduce your biases. If you do this you’ll be rewarded with better returns and greater success. For instance, if you’re challenged by herd behaviour ask yourself why you are so interested in a new investment. Do you really understand the investment? Would you still invest in it if it weren’t popular? Being aware of your financial biases and having a financial plan in place will ultimately guide you towards making sound investment decisions.