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Behavioural finance: How not to be your own biggest enemy!

19 Jun 2023

Neha Sahni

Director, Global Market Strategist, HSBC Global Private Banking and Wealth

Key Takeaways

  • Despite being one of the smartest species on the planet, human beings aren’t always rational with their decisions especially when it comes to investing. Our emotions and personal beliefs often play a key role in our investment decision-making process.
  • This is where the science of behavioural finance comes in, which focuses on the various psychological factors and emotions that impact investors’ decisions in the financial markets.
  • We explore six common cognitive biases that impact individual investors and ways to address them. A rules-based investment strategy is a good way of avoiding behavioural biases, because it reduces the chance of trading on impulse or being driven by fear and greed.

What is Behavioural Finance?

Behavioural finance is a field of study that focuses on psychological factors driving investors’ decisions in the financial markets. By blending finance and psychology, behavioural finance tries to identify biases that lead investors to make irrational investment decisions and demonstrates how difficult it can be to get rid of these human follies even when they are told that their choices aren’t optimal. Several behavioural finance studies show that financial markets can be influenced by investor sentiment, which may sometimes be too optimistic or pessimistic, and deviate from underlying fundamentals.

Common cognitive biases that impact investors’ decision-making abilities

  1. Anchoring and adjustment bias: people tend to estimate based on initial guesses or not-so-relevant information to assess the value of an asset. They also do not adjust to new information.
  2. Overconfidence bias: thinking we know more than we do fuels irrational investment decisions, leading to sub-optimal returns. The general belief that they can outsmart everyone else makes individual investors trade more frequently, adversely impacting their returns.
  3. Investor myopia: this represents an investor’s impulsive behaviour driven by greed or fear. Hype created on various social media platforms about the attractiveness of an asset could lead to a feeling called FOMO (fear of missing out).
  4. Herd behaviour: the tendency to blindly follow the crowd makes people feel safe in a community. Mimicking what other investors are doing without due diligence will lead to speculative frenzies (e.g. the dot com bubble).
  5. Disposition effect: investors sell winners too early and ride losers too long. This is because people dislike incurring losses much more than they enjoy making gains, and end up losing even more. The disposition effect could therefore prove to be costly, if left unchecked.
  6. Status-quo bias: Humans prefer the safety of the current state. This explains why people prefer to hold on to their savings in cash, rather than invest, even though inflation will erode the purchasing power of their savings overtime. When they invest, the tendency of loss aversion leads them to avoid taking small, calculated risks even when they’re worth it.

Take the emotions out and embrace the investment process

FOMO

Fear of Missing out is often:

 JOMO
Joy of Missing out is when
  • Driven by the urge to make short term gains.
  • Driven by social media type and herd behaviour.
  • Evoked by the feeling of 'being left out' because others appear to be doing it.
  • You don't feel the need for constant stimulation.
  • You let the latest hype pass- Don't underestimate the value of doing nothing.
  • Don't time the markets and invest for the long run.
  • Take emotions out by pre-committing to a rules based investment process.
  • Keep faith in your solid investment process and stick to it

Take the emotions out and embrace the investment process

FOMO

Fear of Missing out is often:
  • Driven by the urge to make short term gains.
  • Driven by social media type and herd behaviour.
  • Evoked by the feeling of 'being left out' because others appear to be doing it.
  • Driven by the urge to make short term gains.
  • Driven by social media type and herd behaviour.
  • Evoked by the feeling of 'being left out' because others appear to be doing it.
JOMO
Joy of Missing out is when
  • You don't feel the need for constant stimulation.
  • You let the latest hype pass- Don't underestimate the value of doing nothing.
  • Don't time the markets and invest for the long run.
  • Take emotions out by pre-committing to a rules based investment process.
  • Keep faith in your solid investment process and stick to it
  • You don't feel the need for constant stimulation.
  • You let the latest hype pass- Don't underestimate the value of doing nothing.
  • Don't time the markets and invest for the long run.
  • Take emotions out by pre-committing to a rules based investment process.
  • Keep faith in your solid investment process and stick to it

How can investors avoid their behavioural biases to achieve better investment outcomes?

Key behavioural bias How to address these biases

Anchoring and adjustment bias

1. Don’t try to address all biases at once. Identify the top two or three biases that impact your investment decisions the most and try to continuously keep those biases or behaviours in check.

 

2. Adopt a rules-based strategy that combines core holdings (also known as “Strategic Asset Allocation”) and thematic investments (often referred as “Tactical Asset Allocation” or “satellites”) in a well-diversified portfolio, along with periodic portfolio reviews. This strategy statistically delivers positive outcomes over the long term.

 

3. Remove discretion from day-to-day decision making around trading and investment, and stick to your investment strategy over the long term. This should protect you from your conscious and unconscious behavioural biases and stop you making impulsive decisions
Overconfidence bias
Investor myopia
Herd behaviour
Disposition effect
Status-quo bias

How can investors avoid their behavioural biases to achieve better investment outcomes?

Key behavioural bias

Anchoring and adjustment bias

Anchoring and adjustment bias
How to address these biases

1. Don’t try to address all biases at once. Identify the top two or three biases that impact your investment decisions the most and try to continuously keep those biases or behaviours in check.

 

2. Adopt a rules-based strategy that combines core holdings (also known as “Strategic Asset Allocation”) and thematic investments (often referred as “Tactical Asset Allocation” or “satellites”) in a well-diversified portfolio, along with periodic portfolio reviews. This strategy statistically delivers positive outcomes over the long term.

 

3. Remove discretion from day-to-day decision making around trading and investment, and stick to your investment strategy over the long term. This should protect you from your conscious and unconscious behavioural biases and stop you making impulsive decisions

1. Don’t try to address all biases at once. Identify the top two or three biases that impact your investment decisions the most and try to continuously keep those biases or behaviours in check.

 

2. Adopt a rules-based strategy that combines core holdings (also known as “Strategic Asset Allocation”) and thematic investments (often referred as “Tactical Asset Allocation” or “satellites”) in a well-diversified portfolio, along with periodic portfolio reviews. This strategy statistically delivers positive outcomes over the long term.

 

3. Remove discretion from day-to-day decision making around trading and investment, and stick to your investment strategy over the long term. This should protect you from your conscious and unconscious behavioural biases and stop you making impulsive decisions
Key behavioural bias Overconfidence bias Overconfidence bias
How to address these biases
Key behavioural bias Investor myopia Investor myopia
How to address these biases
Key behavioural bias Herd behaviour Herd behaviour
How to address these biases
Key behavioural bias Disposition effect Disposition effect
How to address these biases
Key behavioural bias Status-quo bias Status-quo bias
How to address these biases
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