BEHAVIOURAL finance attempts to explain and increase the understanding on how humans react towards money, investment as well as how the emotional processes influence financial decision.
Behavioural finance consists of three important aspects – psychology, sociology and finance. Essentially, behavioural finance attempts to explain the what, why, and how of finance and investing from a human perspective.
Below are some behavioural concepts that you should understand as an investor:
Confirmation bias
The theory behind confirmation bias explains that we unconsciously tend to disregard or ignore information that goes against our views. We only look for information that confirms our beliefs.
Hence, we are biased towards finding information that will confirm our beliefs only. Our biases tend to limit our ability to make purely rational investment decisions.
Whether the investment is bullish or bearish, we need to spend some time studying the views of others with whom we disagree. By doing this, we can either strengthen our existing views or understand the potential flaws in our current thinking.
Over-confidence
As human beings, we tend to over-estimate our own skills and ability to predict success. Confidence to a certain level is needed in life. If we are not optimistic, we might not develop to the next level in our quest to accumulate the needed wealth.
It takes confidence to take risk, plan for the future and defer gratification, but over-confidence often leads us to having an unrealistically positive view on financial decisions.
From my experience, investors also tend to take high risk (uncalculated risk) when they are over-confident, hence leading them to be greedy. It’s good to regularly challenge our investment views.
Herd behaviour
Herding is the idea where people feel most comfortable following the crowd and tend to assume the consensus view to be the correct one.
Most investors look to see what everyone else is doing – and then follow suit – getting embroiled into the most over-hyped investment instrument. This can result in massive bubbles which when they burst, cost investors badly.
I think most of us still remember the Geneva Gold Investment scam and many other forex trading hype which resulted in losses in millions.
Gambler’s fallacy
Humans tend to be over-confident and illogical when predicting random future events. One mistake they make is thinking that past events have a connection to future events.
For example, if someone flips a coin, the odds of the coin coming up heads are 50/50. Even if the coin comes up heads for five tosses in a row, the odds don’t change. They are still 50/50 for the sixth toss.
But gambler’s fallacy makes people think that the sixth toss will be tails. They think it must be this way because the previous five tosses all came up heads. This is a guess based on intuition, not a certainty based on statistical probabilities. This bias can be dangerous.
I hope this guide has provided you with useful insights on the concepts of behavioural finance. As humans, we are effective decision-makers but tend to possess flaws that can cause problems in the realms of investing.
Understanding what we lack can help us avoid these problems and invest better. Behavioural finance is one of the important pillars in financial investment that we should emphasise on before embarking on our investing journey. – Aug 7, 2022
Gunaseelan Kannan, CFP, is a licensed financial planner with Blueprint Planning Sdn Bhd. He is also a certified member of Financial Planning Association of Malaysia (FPAM).
The views expressed are solely of the author and do not necessarily reflect those of Focus Malaysia.
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