Behavioural finance: How psychology affects investors

Some of my biggest investment mistakes have happened when I’ve let my emotions take control. I’m not alone in this, and business academics have increasingly focused on this subject, known as ‘behavioural finance’.

In this video, I explain three well-known ‘biases’ that humans have, and which can lead to poor investment returns. 

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Transcript

Hi. When I think back to some of the big investment mistakes I've made in my life, I think a lot of those mistakes were driven by my emotions and my psychology, rather than a misunderstanding about the fundamentals driving a share.

So here's just one example why, on more than one occasion, I analysed a share, looked at it quite closely, and decided not to buy.

Let's say the share price was £1.00. I decided not to buy this share, and then a few weeks later or maybe a few months, I've seen the share price take off and hit £1.50. At that point, I said, "Oh no. I missed out on all of that profit. I was so close to buying that share. Why didn't I buy?"

I then I let my emotions take control, and I go out and buy the share at £1.50 – 50% higher than the original price I considered. I buy at £1.50, and I just do it in a hurry. I just press buy without doing any fresh analysis on the company, any fresh analysis on its sector and the industry that it's operating in. More often than not, when I've done that – when I've chased a share price due to emotion – I've ended up losing money.

That's just one example of how emotion can push you into bad investment decisions.

There are academics who've been studying this whole area for a long time now. This whole research area is known as ‘behavioural finance’.

What people have discovered is there's a whole range of biases that humans have where their emotions, their psychology can lead them to make poor investment decisions. So there are loads of biases out there. But in this video, I'm just going to look at three of the best known.

Loss aversion

So let's start by looking at loss aversion. Put very simply, humans don't like to lose money. You might say that's not a very amazing revelation, and it's not, but that desire not to lose money can lead to investment mistakes.

Let's say you brought a share at £1.00, and you then see the share price fall to 80p. The natural human reaction is to say I'm not going to sell at 80p, because I don't want to sell at a loss. I want to make profit.

So instead of selling at 80p, you sit there and if things go quite well. Eventually, the share price goes back up to £1, or maybe a bit higher, and you sell your shares at £1.20, and you say “great, I didn't sell at a loss. I made a small profit. All is well.” But actually, that decision to hang on regardless at 80p, may well have been a mistake.

For starters, the share price actually might carry on falling, because the company might be in trouble. So you might never cover your losses. And even if the share price does move back up to £1.00, that doesn't mean that your original decision to stay in at 80p was correct, because actually, at that point, when the share was 80p, there may have been other better investment opportunities out there in the stock market.

You might have done better to sell up at 80p, take your loss, invest into a better share, and make a good profit on that share in time. Loss aversion can cause you to stay with bad shares and you either make big losses or potentially not as much profit as you might make elsewhere.

Recency bias

Another bias that the academics focus on is recency bias. That’s the idea that, if we've been recession for two years and times are tough, it's natural to say well, things are going to carry on in the same vein for another two or three years to come. We're going to have a long recession. But actually, recessions do normally end fairly quickly, and if you buy shares in the middle or towards the end of the recession, you'll often make big profits.

Remember: whatever the situation is now, don't assume that it will carry on the same way forever. That's what the human psychology expects, but experience and history suggest that actually, it's different. That's not how things pan out.

Anchoring

The final bias that I'm going to look at is anchoring. This is where you anchor your whole decision to invest on one particular fact to the exclusion of all else.

Think back to the example I gave at the beginning, where I talked about buying at £1.00, and the share price whizzes up to £1.50. If I buy at £1.50, I may be anchoring my decision purely on the one fact that there's been a big surge in the share price in the last couple of months.

That anchoring on one fact may mean you don't look at all of the other facts that are out there, or the fundamentals of the company that are out there, and you make a poor investment decision.

Another example of anchoring is where, as with online retailer ASOS. Its share price was £70.00. It's now about £24.00. You might say, "Well, wow, it was at £70.00 a few months ago, £24.00 - it must be a bargain. I'll buy in now." So you're anchoring your whole decision on the fact that the share price was much higher six months ago. But that doesn't mean that ASOS is going to be a good investment. There are all sorts of reasons to suggest that ASOS may actually be a bad investment at the current share price of £24.00.

The circumstances of the company may change. Its fundamentals may change or the market may just be focusing on different issues. Whatever the rationale, just anchoring your decision on one fact, where the share price was six months ago, may lead you to investment disaster.

Now, as I said at the beginning, behavioural finance is a big area. There's load of other biases out there that the academics have discovered that may be triggering poor investment decisions. But I hope in this video, I've just given a brief introduction and got you thinking about the fact that when you consider buying or selling a share, do remember that your emotions may be pushing you in the wrong direction.

So instead of letting your emotions boss you around, try and focus on the fundamentals. Find focus, rationally, on the core facts and more likely then, you'll make the right investment decision.

I'll be back with another video soon. Until then, good look with your investing.

 

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