Understanding how the mind can help or hinder investment success
What behaviours prevent us from making the right investment choices? And how can we improve our investment decision making? The study of behavioural finance could lead us to better understand the financial decisions we make.
Behavioural finance is a branch of economics that tries to understand the psychological and behavioural factors which, alongside conventional economic theory, explain why we, as investors, act the way we do.
Twenty years ago, behavioural finance was mostly a scattered collection of research by those who dared to question the classical views of finance. In 2002 however, Daniel Kahneman put behavioural finance front and centre by winning the Nobel Prize in Economics for his work in applying psychological insights to economic theory. The major downturn experienced during the financial crisis of 2007-2008 also heightened interest in behavioural finance. Since then, it has catapulted to become a source of rationale for investors’ decisions.
So, how does behavioural finance contribute to our knowledge of finance? At its core, it provides a framework that not only explains investor behaviours, but also educates investors to help them make more informed decisions.
Understanding behavioural finance
According to conventional investment theories, the price of an asset – such as a share or a bond – is based on rational foundations. These include the financial health and performance of a company or an economy. Classical views of finance assume that people can separate their emotions from their decision making. It holds that given the same level of information investors will make the same choices in a way that aims to maximise their returns and minimise their risks.
However, in practice we often see that this is not the case, and investors can make unexpected, even seemingly irrational decisions. Most people know emotions affect decisions - people in the industry commonly talk about the role greed and fear play in driving stock markets for instance.
Behavioural finance theorists point to investment ‘bubbles’ as primary evidence that market prices can be affected by the irrational behaviour of investors. They cite the Dutch tulip bulb mania of the 1630s, the South Sea Bubble of the 1710s, the junk bond crash of the 1980s and the ‘dot.com’ Internet stock bubble of the 1990s as examples of how investors can get caught up in the enthusiasm for something new and exciting. More recently the value of one Bitcoin rose to nearly US$20,000 in late 2017 but had fallen to around US$3,000 less than a year later.
Behavioural finance theorists propose psychology-based ideas to explain these stock market anomalies. One example that behavioural finance theorists use to illustrate how the actions of investors appear to go against perceived wisdom is the ‘January effect’.