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13 July 2022

An Introduction to Behavioural Finance

There are many theories when it comes to finance, with many exploring the deepest intricacies of financial markets, big business and investor behaviour, but the concept of behavioural finance is one of the more interesting.
 
Blending finance and psychology, this theory suggests that psychological biases and influences can affect the financial behaviours of investors, noting that these biases and influences can explain any number of stock market anomalies including sudden and severe rises and falls in stock prices.
 
The theory of behavioural economics, a concept similar to behavioural finance, first came to prominence in the 1970s and has seen countless books written and studies conducted on the topic since, while many universities also offer courses exploring the wide-ranging topic.
 
Put simply, studies in behavioural finance found that investors often behave irrationally, exhibiting traits that cannot be telegraphed, culminating in people making financial decisions based on emotion rather than rationale. For example, investors have been known to hold positions which are in decline rather than selling the holding and accepting a loss.
 
Behavioural finance encompasses various different ‘biases’, traits which can cloud their judgement, are often counterproductive and can have negative consequences. For example, confirmation bias suggests that investors accept information that confirms their already-held beliefs. Familiarity bias, meanwhile, is when people invest in what they know, such as domestic companies or firms local to them, while experiential bias occurs when an investor’s memory of recent events may lead them to believe that an event is likely to occur again. A prime example of this event was the 2008/09 financial crisis in which investors suddenly left the stock market in huge numbers. After the event, many investors took a poor view of the markets and the negative experience of such a crash in the market increased their belief that a crash could reoccur. Of course, the markets went on to recover in the following years.
 
The theory of behavioural finance can also explain two of the most common phenomena in the investing world – bull and bear markets. The concept argues that investors often have an overriding herd mentality which can take over their usual thought processes and rationale and lead to decisions being made with little independent thought. When a market moves up or down, investors are prone to the fear that others have a greater knowledge than they do and subsequently feel an impulse mimic their peers. Therefore, when stocks begin to rise or fall in value, masses of investors may follow suit, driving share values up or seeing them crash down. The herd mentality theory contributed in part to the dot com bubble of the late 1990s.
 
By studying how and when investors deviate from rational expectations, behavioural finance may provide a roadmap to help investors make more rational and considered decisions relating to financial matters. Therefore, as the Corporate Finance Institute suggests, it is key to eliminate reflexive thinking. This method, which involves decisions made on gut instinct, is suggested to be our default. On the other hand, the reflective approach to investing is more based on a logical and methodical thought process where decisions take time to implement.
 
In order to move from the reflexive way of irrational thinking to the reflective method requires the investor to reprogram their thought process to take a more logical, considered course of action. Of course, changing the way we look at the world is no easy task, hence why people often entrust their investments to a qualified investment manager. So, by thinking logically and impartially without having one’s vision clouded by the traits and biases set out in the theory of behavioural finance, one can try to eliminate the irrational thinking that may lead to rushed investment decisions.
 
In the words of former Fidelity Magellan Fund manager Peter Lynch, “know what you own, and know why you own it.”
 
This article was taken from the February 2022 issue of Market Insight. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.
 
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.
 
An Introduction to Behavioural Finance

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