Have you ever noticed that every time you buy a stock, its price starts to drop, but as soon as you sell it, the price begins to rise? Repeatedly caught in a cycle of buying high and selling low, what felt like a confident move to earn turns into a series of regrettable losses. Or perhaps, the price of an asset you've purchased increases afterwards and you regret not buying more. These scenarios, familiar to many investors, raise questions. Do you wonder why such patterns occur? This article introduces the concept of behavioural finance—a field that goes beyond mere financial knowledge to understand how human nature impacts financial investments.

• Behavioural Finance is a field that studies how psychological factors lead investors to make irrational decisions in financial markets, potentially causing abnormal market behaviours
• Cognitive and Emotional Biases: Investors exhibit various cognitive and emotional biases while making financial decisions, affecting their investment strategies. These biases can explain the unconventional actions often taken by investors
• Learning from Biases: Though completely avoiding these biases is unlikely, investors can learn about their own behavioural patterns. Understanding these biases enables investors to manage their assets more scientifically and rationally

What is Behavioural Finance?

Behavioural Finance merges psychology, cognitive science, economics, and financial studies into an interdisciplinary field, examining how traditional financial theories of markets and pricing intertwine with human behaviour. It seeks to understand why individuals in financial markets often make decisions that are irrational and counterintuitive. This branch of finance veers away from the "rational economic agent" model assumed by traditional finance, recognizing that psychological factors can steer investors to make decisions that stray from rational expectations.

In traditional finance, markets are viewed as efficient and rational, with participants acting solely to maximize self-interest, equipped with complete information and unbounded rationality. Behavioural finance, however, by investigating the irrationalities present in the market, exposes the limitations of this assumption. For instance, investors might make illogical financial decisions due to overconfidence, herd behaviour, or an excessive aversion to loss, all psychological factors.

The implications of behavioural finance for financial markets are significant. It elucidates that investors often make decisions based on a complex web of psychological and emotional factors, not just objective analysis of information. This is particularly evident in the volatility of the stock market, asset price bubbles, and the contagion of market panic.

Behavioural finance can be analysed from various perspectives. While the stock market returns are often presumed to be influenced by psychological behaviour, many different viewpoints exist. In behavioural finance, it's assumed that financial participants are not entirely rational and self-controlled but are psychologically influential, with tendencies toward normalcy and self-regulation. Financial decisions often hinge on the psychological and physical well-being of investors, and as their overall health fluctuates, so does their mental state, affecting their decision-making and rationality concerning all real-world issues, including those specific to finance.

A critical aspect of behavioural finance research is the impact of biases. Biases may arise from a multitude of causes. Understanding and categorizing different types of behavioural finance biases is crucial when researching or analysing outcomes and results within industries or sectors.

Investors’ Cognitive and Decision-Making Biases

Humans possess inherent biases or conceptual deviations that shape our worldview and decision-making processes, including financial decisions. Most biases fall into two main categories: cognitive and emotional biases, which can be further subdivided into various types.

Confirmation Bias:

This bias describes the tendency of investors to seek out information that confirms their existing beliefs or hypotheses, rejecting information that contradicts them. If an investor is considering buying a company's stock, they typically focus on positive rather than negative information to reinforce their initial thoughts, even if the positive information isn't entirely accurate or impartial. Overcoming this bias involves challenging oneself to consider a broad range of information, resulting in a more informed decision even if the conclusion remains the same.

Recency Bias:

This bias occurs when investors give undue weight to recent events, believing these events are more likely to happen again. After the 2008 financial crisis, many investors pulled out of the stock market, pessimistic about market prospects and expecting further economic hardships. Experiencing such negative events amplified their bias towards expecting similar occurrences. However,the market rebounded starting from March 2009 (faster than most investors expected) and the market continued to rise in the following years. Counteracting this bias involves reviewing historical events for perspective and discussing with professionals, which can help build a resilient investment portfolio.

Loss Aversion:

Traditional economics assumes humans are completely rational, with gains and losses affecting rational agents equally. In reality, individuals exhibit a clear preference for gains over losses. When this loss aversion is applied to investing, it often triggers the disposition effect — investors sell winning investments and hold onto the losing ones. Investors want to quickly realize gains; however, when facing losses, they measure performance against their personal entry price, overlooking any fundamental or attribute changes in the investment. Such emotions hinder investors from proactively addressing the real economic conditions of their portfolio.

Familiarity/Overconfidence Bias:

This bias arises when investors gravitate towards familiar investments, like domestic companies or industries they know superficially. This bias leads investors to overestimate their ability to select investments, feeling a false sense of security and taking on risks beyond their capacity. To mitigate this, thorough market research and comprehensive information gathering are essential.

Herd Mentality Bias:

This group behaviour occurs when investors, in the face of uncertain information environments, are influenced by others' decisions or overly rely on public opinion, neglecting their own information. The 1997 Asian financial crisis illustrates this, as people in Southeast Asian countries rushed to exchange local currency for dollars, leading to bank runs despite government pleas for calm. Overcoming herd mentality requires the courage to hold dissenting views, maintaining critical thinking, and adherence to one's principles.

Anchoring Bias:

Investors may become irrationally or emotionally attached to a perceived value, causing sluggish responses to economic, corporate, or market developments. For example, if an investor reads two investment bank reports on a target asset—one predicting a 20% rise and the other 40%—they might subconsciously anchor on the 40% potential increase, subtly influencing their decision-making when selling.

Therefore, when making investment decisions, consider the credibility of information sources, whether timing and valuation remain consistent, and most importantly, does this choice support your pre-set goals? Reflecting on these questions can help determine if the investment truly suits you.

Beyond these common psychological biases, there are many other types. We cannot always perform optimally on our own, which is why professional and independent advice can add value, helping to overcome subconscious investment errors.

The Significance of Behavioural Finance

The advancement of behavioural finance has not only enriched our understanding of financial markets but also provided new tools and strategies to counteract the irrational behaviours that often occur within them.

From behavioural finance, investors learn to identify and overcome cognitive biases such as overconfidence and herd mentality, as well as to avoid emotional decision-making. It also enables better evaluation and management of risks, particularly in the creation and maintenance of diversified investment portfolios. Moreover, behavioural finance encourages a long-term perspective, steering clear of impulsive decisions driven by short-term market fluctuations and promoting continual learning and adaptation to market changes.

• Diversified Portfolios: Diversification and risk spreading can help reduce the likelihood of irrational behaviours.
• Long-term Perspective: Behavioural finance advocates for long-term investment strategies to prevent knee-jerk reactions to market volatility.
• Learning and Adapting: Markets are in constant flux, necessitating that investors continuously learn, adapt, and adjust strategies accordingly.
• Establishing Rules: Creating personal investment portfolios and rules, and adhering strictly to predetermined processes can minimize the impact of emotions on investment decisions.
• Professional Consultation: Regular communication with professionals can mitigate various psychological biases and keep investors abreast of market trends and investment ideas.

Institutional investors, acknowledging behavioural biases, can develop their own trading models and strategies based on the principles of behavioural finance. Furthermore, after identifying clients' rational and irrational behaviours, tailored advice can be provided to prevent them from falling into pitfalls.

Conclusion

Behavioural finance theory suggests that security market prices are not solely determined by the intrinsic value of the securities but are also significantly influenced by the behaviours of investors. The psychological and behavioural patterns of investors greatly impact the pricing and fluctuations of the securities market. Various technical and fundamental analyses are utilized as attempts to summarize stock movements and trajectories, aiming to improve the probability of successful trades. By understanding and mastering the principles of behavioural finance, investors can make their trading more rational.