Many people often think that money and emotions sit in two different parts of the brain; one is logical and requires objective thinking. The other is feeling, passion and response. However, the two often cross paths, sometimes without us even knowing it; we react emotionally to financial decisions. This is known as behavioural finance, and there are many different types of behavioural finance that one will experience throughout their life. Here, I want to explore each, and point out the pitfalls & traps we can fall into.
Herd Mentality
I feel that this may be one of the most common forms of behavioural finance that I see. It is very similar to 'FOMO' or following the crowd. Very frequently in life do people jump on the bandwagon of a particular fad or craze. These fads are often fleeting, and don't stick around for too long (think of Pogs, Beanie Babies or The Atkins Diet), but during that short period of time everyone was talking about them and hyping them up. Similarly, think of NFTs, Dogecoin & Tulip Mania (the last one is real, look it up) in investing. Most of these fads don't equal long-term gains, so it's important not to get swept up in the excitement and think about long-term investment strategies.
Recency Bias
Recency bias tempts investors with fleeting gains and overshadows the broader market view. Many investors tend to be swayed by short-term views and information, and it's incredibly dangerous for investors to extrapolate short-term recent trends far into the future. It can tempt an investor to abandon the critical principles of diversification, to focus on whatever has been trending over the past few years. This can be particularly risky if the investor already has fell privy to herd mentality. Take a look at the MSCI Emerging Market & the S&P 500 trends below; the dominance of emerging markets from 2000 to 2010 might have led some investors to believe that this upward trend could last forever. This, however, proved to be a misconceived notion, as we can see that from 2010 onwards, this has not been the case & the S&P has overshadowed the latter.
Loss Aversion
Imagine; you've spent a lot of time picking and choosing what stocks you want to invest in, but a bad market downturn massively affects your position, causing your investments to take a temporary downturn. Of course, this can lead you to feeling a lot of emotional pain and strife- you may no longer feel confident in your investments, and because of all the negativity this experience has caused, you contemplate withdrawing some, if not all of your investments. This can lead to hasty decisions, potentially derailing your investment strategy. Understanding the impact of loss aversion bias is crucial in navigating market uncertainties. It's best to avoid this by frequently reviewing your investments and portfolio, ensuring your investment choices are aligned with your long-term financial goals.
Familiarity Bias
Have you ever found yourself sticking to what you know in investing, just as you might choose a familiar path over an unknown trail? This is familiarity bias at work. It's natural, but it might limit your investment horizons. Maybe some investors will only put their money in fixed deposits, because that is all they have ever known. Some may put their money in stocks in the same sector they work in, because they are familiar with that industry. It's important to remember that not everything in life is going to be achieved following one path. When it comes to investments, diversification, investing for the long-term, and time in the market vs. timing the market, are key principles we must stick by.
Even the most rational minds can be swayed by emotions in decision-making. Behavioural finance is about the gap between what we should do – following our rational intentions – and what we actually do – which is often something quite different. This gap can be large and incredibly costly. No matter how rational we think we are, everyone is prone to letting emotions guide their decision-making. The cost of one behavioural mistake – such as moving our portfolio to cash at the trough of a bear market – can outweigh any other investment decision we make. Advice that helps us avoid such situations can be transformative.
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