The effect of psychology on investors

The effect of psychology on investors

You should base financial decisions on logic and facts. But psychology can have a much larger effect than you think, and it can lead to you making decisions that aren’t right for you. Read on to find out more about what behavioural finance is and how it could affect you.

“Behavioural finance” was first coined in the 1970s by economist Robert Shiller and psychologists Daniel Kahneman and Amos Tversky. They used the term to refer
to how unconscious biases and previous experiences affect the way people make financial decisions.

It can be used to explain why investors can make knee-jerk decisions or invest in opportunities that aren’t in their own best interest. Rather than relying purely on facts, investors often have biases thataffect how they react to certain situations.

Finance bias can lead to “irrational” decisions through shortcuts

There’s a reason why people often make decisions based on biases: they can make the decision-making process quicker.

If you imagine how many decisions you need to make every single day, it’s easy to see why this kind of decision-making can be useful. From what to eat for breakfast to which way totravel to work, it’d take up all your time if you carefully went through the facts for each decision you make. So, you make shortcuts by using biases.
However, while it can be a useful process in your day-to-day life, bias can have a negative effect when you’re making important decisions, including financial ones.

Behavioural finance covers five concepts:

1. Mental accounting
Mental accounting can be incredibly useful when you’re managing a budget. However, inflexibility could mean you miss out on opportunities. The concept refers to how people may designate money for certain purposes. So, you may have different savings accounts for various goals. It’s a process that can help you manage your
outgoings and work towards goals. However, it can also lead to irrational decision making. You may not dip into a savings account that you’ve allocated to buying a newcar even when you face an emergency and it’d make sense logically. How you receive the money may also affect how you use it. For instance, you may put off using money thatwas given as a gift in an emergency because you believe it should be used for something special.

2. Herd behaviour
Herd behaviour is something that’s often seen in investing. When you hear that lots of people are selling certain stocks or buying a specific share, it can be easy
to be led by this and follow suit. It can lead to you making decisions that, while possibly right for others, don’t suit you or your circumstances. It’s not just investing where herdbehaviour can have an effect. You may be tempted to purchase an item after a friend has or choose a savings account because someone you know has.

3. Anchoring
When you have some information, you may focus on this – anchoring your views to this data. Setting a benchmark can be useful, but it can mean you don’t take in
other information, especially if it’s contradictory. So, you may hold on to investments even after the value has fallen because you’ve anchored its worth to a previous valuation.

4. Emotional gap
Emotions often play a role in financial decisions. You may sell a stock because you fear that the price will fall, or make an impulse purchase because you’re happy.
Being comfortable with your financial plan is important, but an emotional gap can fuel irrational decisions as you’re more likely to overlook data.

5. Self-attribution
This concept refers to how investors are likely to have overconfidence in their abilities. You may believe you can reliably time the market to maximise profits when
the markets are unpredictable. In this case, it’s common to see “wins” as being down to your knowledge, while “losses” are attributed to things
outside of your control.

Unconscious bias may affect your decisions in ways you don’t expect. If you have any questions about your finances and the decisions you need to make, please contact us.

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

Expires 13/03/25
Approved by the Openwork Partnership on 14 March 2024.