Trading psychology or behavioural finance - a combination of social, psychological, and financial theory. Learn more.
What is behavioural finance?
Behavioural finance is a combination of social, psychological, and financial theory. It attempts to understand how markets and assets can be driven by outside influences rather than just cold, hard fact. For example, it explains how investors' emotions and irrational behaviour may exacerbate fluctuations in asset prices.
Behavioural finance in action
A bank is being investigated for allegedly mis-selling products. In the past, this sort of investigation has resulted in big fines. Investors are immediately fearful that a huge fine awaits the bank, despite no conclusive proof of guilt, so they begin to sell their shares.
The bank's share price falls. An air of pessimism surrounds the stock, which forces other shareholders to capitulate and adds to the selling pressure.
The sell-off becomes extreme and the negative sentiment spills over to the shares of other banks as investors fear repercussions across the sector; shares are widely sold off. This happens despite the fact no fine has been levied and the banks' financial situation remains unaffected.
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Stages of behavioural biases
The decisions investors make are swayed by their convictions. Although there are no single agreed industry definitions, these behavioural examples* illustrate how this can happen:
- Overconfidence and overoptimism — investors overestimate their ability and the accuracy of the information they have.
- Representativeness —investors assess situations based on superficial characteristics rather than underlying probabilities.
- Conservatism — forecasters cling to prior beliefs in the face of new information.
- Availability bias— investors overstate the probabilities of recently observed or experienced events because the memory is fresh.
- Frame dependence and anchoring — how information is presented can affect the decision made, and investors may use an initial piece of information as the basis for subsequent judgments.
- Mental accounting — individuals allocate wealth to separate mental compartments and ignore fungibility and correlation effects.
- Regret aversion — individuals make decisions in a way that allows them to avoid feeling emotional pain in the event of an adverse outcome.
*2008, The Research Foundation of CFA Institute. Behavioral Finance: Theories and Evidence