An Introduction to Behavioural Finance
An Introduction to Behavioural Finance

The aim of this article is to provide an introduction to the field of behavioural finance, and highlight some common psychological biases that can affect investors’ decision-making. By Greg Galton, Private Wealth Analyst.

"We must recognize that the psychology of the speculator militates strongly against his success. For, by relation of cause and effect, he is most optimistic when prices are highest and most despondent when they are at bottom." – Benjamin Graham

The assumption that individuals are rational is one of the most important ideas underpinning modern economic and financial theory, and is key to arguably the most popular and well-practiced theory in modern finance, the efficient markets hypothesis. While in theory this assumption of rationality sounds perfectly reasonable, in reality this doesn’t always apply. Every investor can attest to the fact that investing in the stock market brings about a wide range of emotions, from the pain of watching your investment fall in value to the joy of watching your investment climb higher and higher, and these emotions can lead to mistakes, and errors in judgement. Prompted by recent shocks to the financial system, such as the Global Financial Crisis in 2008, the field of behavioural finance has grown increasingly popular, as investors seek to better understand the markets, and the participants within them. Behavioural finance can be thought of as the marrying of traditional finance and psychology, it aims to explain stock market anomalies, and how human behaviour and psychology can create inefficiencies and mispricings within the market.

To understand the field of behavioural finance, and what we as investors can learn from it, we must first understand it’s counterpoint, the efficient markets hypothesis. This theory states that stock prices reflect all available, public information, and are thus always fairly valued. The three forms of the efficient market hypothesis are:

Strong form efficiency

This idea suggests that stock prices accurately reflect all available information, both public and private, and that it is therefore impossible to earn a return in excess of the market return.

Semi-Strong form efficiency

Semi-Strong form efficiency states that stock prices incorporate all publicly available information, and rapidly adjust to the release of new information. Under this form of efficiency, excess returns can only be earned with non-public information.

Weak form efficiency

This form asserts that stock prices are random variables and not influenced by previous events, and that through careful fundamental analysis, both under and overvalued stocks can be identified, leading to the possibility of generating excess returns above that of the market.

Although it is difficult to empirically test this hypothesis, it is one of the most well-known theories in academic literature. This theory however, relies on the assumption of rational agents, that the participants in the market will act rationally and make carefully considered decisions to maximise their wealth. This seems fairly intuitive, the goal of any investment is to earn a return on that investment, and therefore it makes sense that investors will seek to maximise this return where possible. What the theory fails to take into account however, is that humans are subject to many inherent cognitive biases which can affect their thinking, and thus their decision making.

While it is impossible to completely eliminate these biases from the decision-making process, being aware of them and keeping them in mind, can help minimise the risk of mistakes, and of making poor investment decisions. To help with this, we’ve outlined and explained some of the most common biases investors face, when making investment decisions.


Overconfidence Bias

“People chronically mis-appraise the limits of their own knowledge; that’s one of the most basic parts of human nature.”
Charlie Munger

Overconfidence bias, or the overconfidence effect, refers to a phenomenon in which a person’s confidence in their abilities or judgements, is greater than the accuracy of those abilities or judgements. This could lead to investors being overly optimistic in their forecasts, and ignoring the risks present in an investment, or attributing their own successes to skill and knowledge, while downplaying the success of others as being driven largely by luck. This is especially dangerous for investors who may have initially found success when they first began
investing, their initial success can make them over-confident, leading to mistakes and poor choices. Studies have also found that individuals tend to overvalue information that they have themselves obtained, and be less
confident in information presented to them by others.

The implication of this for investors, is that overconfidence in one’s own abilities and knowledge can lead to poor judgement, and excessive risk taking. By being overconfident in their own knowledge and judgements, investors can sometimes fail to fully appreciate the risks present in an investment, exposing them to poor investments and making poor choices. Being overconfident also comes with the ‘double whammy’ of potentially making a poor investment and missing out on other good opportunities, and then remaining in this losing position rather than acknowledging the mistake, selling the investment and minimising the loss, as the investor believes the investment will eventually ‘come good’.

Being aware of the potential for this bias, can we as investors eliminate this from our decision making process? Ultimately it is impossible to completely eliminate these biases as they are inherently part of human nature, and have evolved with humans over time. Being aware of the potential for overconfidence however, can help investors make calm, carefully considered investment decisions. When considering a potential investment, it is important for investors to think carefully about the information they have gathered, its reliability, and how it could potentially be incorrect or misleading. By essentially acting as their own devil’s advocate, investors can minimise the impacts of overconfidence bias, and reduce their losses from poor investment decisions.


Loss Aversion

"Willingness to take small losses in some stocks and to let profits grow bigger and bigger in the more promising stocks is a sign of good investment management. Taking small profits in good investments and letting losses grow in bad ones is a sign of abominable investment judgement."
Phil Fisher

Loss aversion, also known as regret aversion, refers to the tendency of individuals to want to avoid the feeling of loss where possible. Again, this seems fairly intuitive as we know that every investor to have ever lived has invested with the aim of building their wealth, rather than losing it. Where this gets interesting from a psychological point of view however, is that studies have shown that on the whole, when presented with two choices of a riskier investment with a higher payoff, and one with a guaranteed but lower expected return, individuals overwhelmingly choose the guaranteed, but lower payoff option. For example, if faced with two choices, a payoff with a 50% chance of a $12 return and a 50% chance of an $8 return, and one with a guaranteed $9.50 return, studies suggest that investors are more likely to choose the $9.50 return, even though
the other investment has a higher expected value ($10), and thus seems a more logical choice. This is because generally speaking, avoiding the pain associated with a loss tends to be given a much higher priority by investors. Studies have shown that the emotion investors feel from a loss, is far stronger than that which they experience from an equivalent gain in their investment. This means that the pain which an investor feels from a 10% drop in their investment tends to be much stronger, than the joy experienced when an investment increases in value by 10%. The graph below illustrates this phenomenon, showing that the negative utility ‘gained’ from a decrease in value increases dramatically as an investment falls in value, whereas the positive utility gained caps off and plateaus, even as the investment continues to rise in value.

What are the implications of this in practice then? The average investor’s aversion to loss tends to mean that often, investors will hold on to poorly performing investments for far too long, in the hope that eventually the price will recover, and they can avoid incurring a loss on their investment, and the feeling associated with this. The other side of this, is that many investors will also tend to sell off their strongest performing assets when they experience a sharp rise in value, rather than ‘letting them run’, holding on to them and potentially experiencing greater returns.

This effectively limits the upside of an investment, whilst simultaneously exposing the investor to very large downside in the case that they hold on to their investment for too long. While an investor shouldn’t necessarily sell an investment the second it falls in value (as we know that stocks are volatile, and that prices fluctuate on a daily basis), it is important that if a stock falls in value severely, investors re-evaluate its merits, and the case for the investment. It can often be better to sell a poorly performing investment, take a loss and reinvest the money elsewhere, rather than holding on and hoping for a recovery that never eventuates, thereby only increasing the value of the loss.



Confirmation Bias

“What the human being is best at doing is interpreting all new information so that prior conclusions remain intact”
Warren Buffett

As many professional investors will tell you, the key to finding and evaluating an investment opportunity is thorough research, it both sheds lights on a company’s future growth prospects, and helps unearth risks which may pose problems going forward. It is difficult to evaluate a company’s investment prospects without adequately researching the company first, however when looking for information, investors need to be aware of the potential for confirmation bias, and keep this at the forefront of their minds. Confirmation bias refers to the tendency of people to seek information and ideas which reinforce their pre-existing beliefs, at the expense of information which may contradict or challenge them. This means that investors often tend to form conclusions about their investment theses first, and then seek out and gather information which supports these conclusions. The internet in particular, has opened up a wide range of avenues for investors to source information from, which has seen a massive growth in the amount of available information for investors, and no shortage of people offering their opinions on the markets.

The prevalence of online forums through which investors can discuss stocks and swap ideas, has exacerbated this problem, as investors can find themselves trapped in “echo chambers”, in which positive information (which may be false or misleading) is promoted and reinforced, with little attention paid to more critical information. This positive information can lead to investors hyping a stock to the point it becomes vastly over-valued, and as the price increases more and more investors jump in through fear of missing out, only to be caught short when problems with the underlying business emerge, and the price falls back to earth.

If this bias is hardwired in to our brains then, is it possible for us to avoid it, and prevent it from impacting our decision making process? As with all of the biases we have discussed, it is impossible to be completely free from its effects, however there are steps we can take to mitigate its effects. The key to a balanced argument is finding information which supports your thesis, whilst also acknowledging potential criticisms or counterpoints, and the same holds true when developing an investment idea. Investors must ensure they remain balanced at all times, and actively seek out potential risks and challenges that the company they wish to invest in may face. Warren Buffet spoke of a lesson he took from Charles Darwin, that when he found evidence that contradicted his opinion he would write it down within 30 minutes of finding it, otherwise the mind would tend to reject the evidence and forget about it. It is important that investors seek out evidence critical of their thesis, and that they acknowledge it when they find it. Investors can also combat this bias with the help of their adviser, by bouncing ideas off them, and asking them to offer dissenting opinions. It is essential that investors use information which challenges and critiques their ideas, and an adviser can help with this.


Familiarity Bias

“The worst thing you can do is invest in companies you know nothing about.”
Peter Lynch

One of the most common pieces of advice given to investors is to stick to a circle of competence, and to “invest in what you know”. In many cases this is sound advice, investing in companies within your area of expertise can help avoid potential losses as an understanding of the business may help predict potential risks and challenges that it’ll face, and also potential growth opportunities going forward. The danger of this though is that investors may take it too literally, subjecting themselves to familiarity bias. Familiarity bias suggests that investors tend to favour investments in companies with which they are familiar, without taking into account the fundamentals of the business, at the expense of companies, which may pose more compelling investment opportunities. This can take many forms, it could be as simple as choosing to invest in a company because they make a product that you consume regularly, or because you see a lot of their advertising and assume that they must derive a lot of sales from this. Two major problems that can arise from this, are home country bias, and being over invested in the shares of your employer.

Many companies which are publicly listed offer their employees access to shares through employee share plans, or by tying part of their compensation to an equity component. For senior management, it is seen as good corporate governance to set a large equity component as part of the total compensation package, as this aligns shareholder and management goals, and gives senior management an even greater incentive to act in the best interests of shareholders. For the average retail investor however, investing a significant portion of your wealth in your employer’s shares reduces overall diversification, and leads to a sub optimal portfolio. This is because as an employee your ‘human capital’ is already invested in your employer, by investing more capital in the form of your funds into your employer, you are effectively doubling up, reducing total diversification, and increasing your downside risk in the event the company suffers financial hardship. Using Enron as a case study (albeit an extreme one), many employees owned shares in the company as part of their retirement plan. When the company went bankrupt, employees’ retirement funds nosedived, whilst the employees simultaneously lost their jobs, thus reducing their earnings power in the short term. This example, while extreme, illustrates the negative effects that can arise as a result of being too heavily invested in the shares of your employer. Should the company suffer financial hardship and go into liquidation, the value of your shares would significantly fall (or become worthless), compounded by the loss in earnings as a result of potentially losing your employment. This scenario reinforces just how important diversification is for investors.

Another symptom of familiarity bias is the tendency for investors to be overweight local assets in their investment portfolios, also known as home country bias. Historically this made sense, as transaction costs made the process of directly investing in foreign assets more difficult and expensive than investing in assets within the investor’s home country. However, as technology has improved, and particularly as ETF’s have become more prominent, getting exposure to foreign assets has never been easier. Despite this however many investors are overweight local assets in their portfolios, and it’s largely due to familiarity bias, as investors tend to invest in assets with which they are more comfortable. Overinvesting in local assets ultimately leads to investors missing out on potential returns when international markets do well, and reduces overall diversification, thus leading to sub optimal portfolio construction. The key to avoiding this is to maintain a strict strategic asset allocation, as diversification has proven to be the best method of optimising risk and return within your investment portfolio. Therefore, when making an investment decision, investors need to ensure they consider their strategic asset allocation and remain adequately diversified, to avoid becoming overly concentrated in companies with which they are familiar.


Anchoring Bias

"It is obvious that the performance of a stock last year or last month is no reason per se, to either own it or to not own it now. It is obvious that an inability to "get even" in a security that has declined is of no importance.”
Warren Buffet.

The most important determinant of a company’s future stock price is its ability to grow its earnings, yet investors have a tendency to remain fixated on information which in reality, has no bearing on the stock price. This tendency, also known as anchoring bias, occurs when investors base their thought process off a particular idea, using it as a reference point, even though it may have no impact on the process at all. For example, an investor may become fixated on the price at which they bought a particular stock and use this price as a reference point for future investment decisions, even though this price has no effect on the future valuation of the stock. Another example of this bias can be seen when investors purchase stocks that have suffered sharp declines in
value in the short term. In this instance, the investors are ‘anchored’ on the value of the previous price, and have invested without considering the fundamentals of the business as they believe this now represents a buying opportunity at a discounted price. This gives weight to the saying “don’t try to catch a falling knife”, investors that invest in companies solely on the back of price declines, without considering the underlying fundamentals of the business, will find themselves losing money more often than not.

Even with knowledge of this bias, its causes, and its effects, it can still be difficult to avoid its influences. It’s easy to say that we tend to anchor our thesis on irrelevant information, but identifying this during the investment decision making process often proves difficult. This just reinforces the importance of making investment decisions based on the underlying fundamentals of the business, and the factors that drive potential future earnings growth. Once investors move away from these fundamentals, and start making rash decisions, it becomes all too easy to lose money, and much harder to make it back.


Safeguarding against Bias

"The psychological factors that weigh on other investor's minds and influence their actions will weigh on yours as well. These forces tend to cause people to do the opposite of what a superior investor must do. For self-protection, then, you must invest the time and energy to understand market psychology"
Howard Marks

The existence of cognitive biases, and their effects on market behaviour can be both the individual investor’s best friend, and worst enemy. They create anomalies and mispricings within the market which can create opportunities for outperformance, but also can lead to investors making mistakes and poor investment choices. It’s important for investors to focus on ways they can attempt to safeguard themselves from the effects of biases, however this can only be achieved with a knowledge and understanding of these biases, and their effects.

The importance of diversification as a risk management tool within an investment portfolio can’t be overstated, as such it remains the strongest safeguard against behavioural-influenced mistakes, and poor investment choices. No investor gets every call right, inevitably everyone winds up making poor choices. To accept this is to accept that we are all human, so adequate diversification is necessary to mitigate the impact of these mistakes. The best tool then for building long term wealth, is to develop a strategic asset allocation approach, which suits your personal risk profile, and which is balanced towards growth and defensive assets in such a way that it meets your risk and return needs. This portfolio of diversified assets will offer some protection from bias-induced mistakes, mitigate their impact if they do occur, and ultimately, prove the best tool for building long term wealth.

Simply keeping these in biases mind when considering an investment can also help, it is important to remember to be sceptical and critical. When considering an investment ask yourself if you’re being overconfident at the expense of important information, if you’re becoming fixated on irrelevant information, or making poor choices based on your emotions, and not logic. Learn to embrace negative information which challenges your investment thesis rather than shying away from it, and actively seek out differing viewpoints. Remember to focus on information affecting the underlying fundamentals of a business, and try to avoid becoming fixated on information irrelevant to the investment return. Remember that sometimes it is ok to take investment losses, and to reinvest elsewhere, it is sometimes better to accept a small loss and move on, rather than staying the course and hoping for a recovery, only to experience further loss. No investor is perfect, everyone is subject to these cognitive biases and it is impossible to completely eliminate them (after all we are only human), by keeping these principles in mind however, investors can reduce their impact, and set themselves up for long-term, successful investing. Having an investment adviser to bounce your ideas off or to act as ‘devil’s advocate’ can also be a very important tool in helping you as an individual investor overcome some of these inherent human behaviours.