Whether we realize it or not, behavioural finance plays a major role in our investment decisions.
A subset of behavioural economics, it looks at the role of psychology on investor behaviour and analysis. As Investopedia also explains, it’s a field of study that looks at how psychological influences can play a part in market outcomes.
While it’s a complex topic, we break down some of the basics for you.
Table of contents
- What is behavioural finance?
- What are cognitive errors?
- What are Emotional Biases?
- Overcoming behavioural biases
What is behavioural finance?
Behavioural finance aims to expand on the cookie-cutter approach of traditional finance — which assumes rational investors and efficient markets — and explains the “human” aspect in investing. It explores biases that influence our decisions and the consequences we may face as a result.
In our article on the best wealth management books for Canadians, we actually recommend a bestselling book called Thinking Fast and Slow by Daniel Kahneman, a Nobel Prize-winning economist and psychologist. It’s not a pure investing or wealth management book, but it’s about behavioural theory — where behavioural finance comes from. Essentially, it’s about how we make choices.
Kahneman outlines two systems that drive how we think and choose. System One is fast, intuitive, and emotional. System Two is slow, deliberate, and logical. The book is about the capabilities and biases of both systems. Money is heavily tied to psychology and our emotions. We make financial decisions every day, and the lessons learned in this book can be applied to these choices — both big and small.
In behavioural finance specifically, in its simplest form, the aforementioned behaviourial biases are categorized as either cognitive errors or emotional biases.
Related: Learn more about the psychology behind Thinking Fast and Slow from Kahneman’s 2011 Talk at Google.
What are cognitive errors?
Cognitive errors are “blind spots” in the human mind, driven by mistakes made in how we process statistics, information, and our own memories. It can be separated into two categories: belief perseverance and processing errors.
This category is linked to the discomfort investors feel when new information runs in contrast with previously held beliefs. As a result, investors may exhibit specific biases.
Where individuals maintain prior views by not acting on new information. Consequently, investors risk holding onto a security longer than a “rational” investor.
Example: Paul has most of his portfolio invested in direct real estate since he believes house prices will rise — despite recent reports supporting a downturn.
Where individuals pay more attention to information that supports their views. Investors may inadvertently hold large, concentrated positions that increase their risk exposure.
Example: Paul talks to a real estate agent who agrees that home prices will rise. He then decides to increase his portfolio allocation to real estate to 90% but soon after, the market goes down.
Where individuals use past experiences to interpret new information. Consequently, investors may make decisions based on a small sample that results in more frequent trading, reducing returns.
Example: Paul is invested in Manager A whose short-term performance (1, 2, and 3-year returns) have underperformed its benchmark. He decides to replace this fund with Manager B who has outperformed over the same period. At the end of the year, Manager A starts to outperform Manager B.
Where individuals believe they could have anticipated the outcome of an event after it happened. It’s the “knew-it-all-along” approach that can lead investors to a false sense of overconfidence, causing them to take additional risks.
Example: In the early 2000s, Paul wanted to invest in mortgage-backed securities in the US but had too many expenses at the time. After the crisis happened, Paul attributes his decision to not invest, to his “belief” that the crash was inevitable.
The second category of cognitive error focuses on how individuals interpret information. This includes:
Mental accounting bias
Where individuals value money differently based on its source.
Example: Mary receives her tax refund that she perceives as “free money”. She spends the refund on a lavish vacation instead of placing it in her savings account, which is where she usually deposits her income.
Where a person answers a question differently, based on how it’s asked.
Example: Mary has a low-risk tolerance and meets with an advisor who offers two funds; one that has a 10% chance of loss and the other that has a 90% chance of not losing. She chooses the latter even though both funds have the same probability of loss.
What are Emotional Biases?
Unlike cognitive errors, emotional biases arise from intuition and impulse. From this place, decisions are highly influenced by feelings. Consequently, investors may experience:
Where the thought of losing outweighs potential gains. Investors may reduce their upside potential by selling winners and holding losers.
Example: Ann is invested in stock A which has a large unrealized loss. As the price continues to drop, she decides to hold the stock in hopes of breaking even. The stock subsequently never reaches her purchase price.
Where individuals overestimate their knowledge. Investors may choose stocks with little supporting evidence and consequently underperform the markets.
Example: Ann actively trades tech stocks as she believes she can select undervalued securities. Though some of her stocks yield high returns, her net returns are lower than the market because of trading costs associated with frequent trading.
Where individuals put their short-term needs ahead of long-term goals. Investors may not have enough saved for future goals such as retirement and may resort to riskier assets to generate more income.
Status quo bias
Also known as the “do-nothing” approach. Investors may unknowingly hold securities that have increased in risk above their tolerance level.
Where individuals place a higher value on assets with a sentimental attachment. Like the status quo, investors may hold securities above their preferred risk tolerance and financial goals.
Example: Ann inherits a large stock position but chooses not to sell or hedge the position as it was a gift from her grandmother. She, therefore, inherits more risk than her recommended tolerance level.
Where individuals act out of fear of making the wrong decision. Investors may limit their upside potential by choosing to invest in conservative assets.
Example: Ann previously invested in a high-yield bond that eventually defaulted. As a result, she chooses to invest a majority of her portfolio into government bonds out of fear of losing money in lower-quality bonds.
Overcoming behavioural biases
Overall, cognitive errors are easier to correct than trying to alter an emotional response. But in both cases, we can seek advice from a trusted wealth manager, and conduct our own research to educate ourselves on the investment decision-making process.
We can also ask ourselves appropriate questions to identify our own biases. Being proactive with these approaches can help minimize the pitfalls associated with behaviour biases, leading to more effective investment decisions.
Source: Pompian, Michael M. 2011. “The Behavioural Biases of Individuals.” In Behavioural Finance, Individual Investors, and Institutional Investors. Charlottesville, VA: