Home > Trading Psychology > Behavioural Finance

Behavioural Finance

The field of trading psychology is an incredibly interesting one if you consider the impact of mental and emotional factors on trading outcomes.

There are so many facets of a person’s behaviour that play a role in influencing financial decision making.

Combine this with the stress that the market volatilities and aggressive price fluctuations evoke, it’s no surprise that the study of feelings and how they drive traders to act certain ways has become so popular.

Interwoven within this mesh of psychological concepts is behavioural finance. Referred to as a subset of behavioural economics, behavioural finance suggests that investor behaviours are influenced by psychological elements and biases.

It further proposes that variances within financial markets may be attributed to these factors, for e.g., aggressive price movements of particular asset like stocks.

In fact, growing recognition of this research has prompted renowned institutions like the Securities and Exchange Commission to assign staff to further explore the field of behavioural finance, and its impact on financial transactions.

The influence of biases

One of the core components of behavioural finance has to do with the influence of biases. More specifically, the notion is that biases can be categorised into one of 5 core concepts influencing the market and/or trading outcomes. These are:

Herd behaviour

Herd behaviour refers to those instances when investors or other financial practitioners copy the financial behaviours of a larger majority (i.e., the herd). This behaviour is frequently witnessed in the stock market and often the reason for selloffs or rallies.

Emotional gap

Emotional gap pertains to decision making driven by intense emotions or emotional stress. This behaviour is often the reason why people make illogical decisions.

Self-attribution

Self-attribution involves making decisions with an overconfident reliance on one’s own knowledge or skill. This tends to arise from one’s existing proficiency in a specific domain. In this instance, an investor may deem their knowledge more favourably than others, even if this isn’t objectively true.

Mental accounting

A concept developed by Nobel prize winner and economist Richard Thaler; mental accounting refers to the different values individuals assign to the same amount of money. The value is usually based on subjective criteria and can often lead to irrational investment or trading decisions.

Anchoring

Anchoring in behavioural finance is when people unconsciously use irrelevant information, like the initial price of a security, as a fixed reference point for making later decisions about that security.

Research and analysis within the scope of behavioural finance have also uncovered other individual biases and idiosyncrasies exhibited by investors. These include:

Confirmation bias:

occurs when investors favour information that aligns with their existing beliefs, even if flawed.

Experiential or recency bias:

arises from recent events shaping investors’ perceptions of future occurrences.

Loss aversion:

the tendency to prioritise avoiding losses over achieving gains leading to risk-averse behaviour.

Familiarity bias:

manifests when investors favour familiar investments, potentially limiting diversification. This often leads to a preference for domestic or locally known investments, neglecting broader market exposure.

Each bias reflects cognitive tendencies influencing decision making in the financial realm, impacting how investors assess and respond to information, events, and potential risks.

TOOLS

EDUCATION