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[Start Investing] Behavioural Finance: How not to be your own biggest enemy!

16 Jul 2023

Neha Sahni

Director, Global Market Strategist, HSBC Global Private Banking and Wealth

Key Takeaways

  • Despite being one of the smartest species on the planet, human beings aren’t always rational with their decisions especially when it comes to investing. Our emotions and personal beliefs often play a key role in our investment decision-making process.
  • This is where the science of behavioural finance comes in, which focuses on the various psychological factors and emotions that impact investors’ decisions in the financial markets.
  • We explore six common cognitive biases that impact individual investors and ways to address them. A rules-based investment strategy is a good way of avoiding behavioural biases, because it reduces the chance of trading on impulse or being driven by fear and greed.

What is Behavioural Finance?

Behavioural finance is a field of study that focuses on psychological factors driving investors’ decisions in the financial markets. By blending finance and psychology, behavioural finance tries to identify biases that lead investors to make irrational investment decisions and demonstrates how difficult it can be to get rid of these human follies even when they are told that their choices aren’t optimal. Several behavioural finance studies show that financial markets can be influenced by investor sentiment, which may sometimes be too optimistic or pessimistic, and deviate from underlying fundamentals.

Common cognitive biases that impact investors’ decision-making abilities

  1. Anchoring and adjustment bias: people tend to estimate based on initial guesses or not-so-relevant information to assess the value of an asset. They also do not adjust to new information.
  2. Overconfidence bias: thinking we know more than we do fuels irrational investment decisions, leading to sub-optimal returns. The general belief that they can outsmart everyone else makes individual investors trade more frequently, adversely impacting their returns.
  3. Investor myopia: this represents an investor’s impulsive behaviour driven by greed or fear. Hype created on various social media platforms about the attractiveness of an asset could lead to a feeling called FOMO (fear of missing out).
  4. Herd behaviour: the tendency to blindly follow the crowd makes people feel safe in a community. Mimicking what other investors are doing without due diligence will lead to speculative frenzies (e.g. the dot com bubble).
  5. Disposition effect: investors sell winners too early and ride losers too long. This is because people dislike incurring losses much more than they enjoy making gains, and end up losing even more. The disposition effect could therefore prove to be costly, if left unchecked.
  6. Status-quo bias: Humans prefer the safety of the current state. This explains why people prefer to hold on to their savings in cash, rather than invest, even though inflation will erode the purchasing power of their savings overtime. When they invest, the tendency of loss aversion leads them to avoid taking small, calculated risks even when they’re worth it.

Take the emotions out and embrace the investment process

Set Title

FOMO

Fear of Missing out is often:

JOMO
Joy of Missing out is when:
   
  • Driven by the urge to make short term gains.
  • Driven by social media type and herd behaviour.
  • Evoked by the feeling of 'being left out' because others appear to be doing it.
  • You don't feel the need for constant stimulation.
  • You let the latest hype pass- Don't underestimate the value of doing nothing.
  • Don't time the markets and invest for the long run.
  • Take emotions out by pre-committing to a rules based investment process.
  • Keep faith in your solid investment process and stick to it.
   

Set Title

FOMO

Fear of Missing out is often:

   
JOMO
Joy of Missing out is when:
   

FOMO

Fear of Missing out is often:

  • Driven by the urge to make short term gains.
  • Driven by social media type and herd behaviour.
  • Evoked by the feeling of 'being left out' because others appear to be doing it.
  • Driven by the urge to make short term gains.
  • Driven by social media type and herd behaviour.
  • Evoked by the feeling of 'being left out' because others appear to be doing it.
JOMO
Joy of Missing out is when:
  • You don't feel the need for constant stimulation.
  • You let the latest hype pass- Don't underestimate the value of doing nothing.
  • Don't time the markets and invest for the long run.
  • Take emotions out by pre-committing to a rules based investment process.
  • Keep faith in your solid investment process and stick to it.
  • You don't feel the need for constant stimulation.
  • You let the latest hype pass- Don't underestimate the value of doing nothing.
  • Don't time the markets and invest for the long run.
  • Take emotions out by pre-committing to a rules based investment process.
  • Keep faith in your solid investment process and stick to it.

FOMO

Fear of Missing out is often:

   
JOMO
Joy of Missing out is when:
   

Source: HSBC Global Private Banking, May 2023

How can investors avoid their behavioural biases to achieve better investment outcomes?
Key behavioral bias How to address these biases
Anchoring and adjustment bias

1. Don’t try to address all the biases at once. Figure out which top two or three biases impact your investment decisions the most and try to continuously keep those biases/behaviours in check.

2. The best way to avoid behavioural biases is to take emotions out of one’s investment decisions by having an investment “pre-commitment” in place .

A rule-based strategies like Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA) are known to statistically deliver positive outcomes over the long term.

Removing discretion from day-to-day decision making around trading and investing reduces the chance of trading on impulse or be driven by fear and greed.

3. Stick to their investment process/strategy over the long run. Doing so should protect investors from their conscious and unconscious behavourial biases and deliver the best possible investment outcomes.

Overconfidence bias
Investor myopia 
Herd behavior
Disposition effect
Status-quo bias
How can investors avoid their behavioural biases to achieve better investment outcomes?
Key behavioral bias Anchoring and adjustment bias Anchoring and adjustment bias
How to address these biases

1. Don’t try to address all the biases at once. Figure out which top two or three biases impact your investment decisions the most and try to continuously keep those biases/behaviours in check.

2. The best way to avoid behavioural biases is to take emotions out of one’s investment decisions by having an investment “pre-commitment” in place .

A rule-based strategies like Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA) are known to statistically deliver positive outcomes over the long term.

Removing discretion from day-to-day decision making around trading and investing reduces the chance of trading on impulse or be driven by fear and greed.

3. Stick to their investment process/strategy over the long run. Doing so should protect investors from their conscious and unconscious behavourial biases and deliver the best possible investment outcomes.

1. Don’t try to address all the biases at once. Figure out which top two or three biases impact your investment decisions the most and try to continuously keep those biases/behaviours in check.

2. The best way to avoid behavioural biases is to take emotions out of one’s investment decisions by having an investment “pre-commitment” in place .

A rule-based strategies like Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA) are known to statistically deliver positive outcomes over the long term.

Removing discretion from day-to-day decision making around trading and investing reduces the chance of trading on impulse or be driven by fear and greed.

3. Stick to their investment process/strategy over the long run. Doing so should protect investors from their conscious and unconscious behavourial biases and deliver the best possible investment outcomes.

Key behavioral bias Overconfidence bias Overconfidence bias
How to address these biases
Key behavioral bias Investor myopia  Investor myopia 
How to address these biases
Key behavioral bias Herd behavior Herd behavior
How to address these biases
Key behavioral bias Disposition effect Disposition effect
How to address these biases
Key behavioral bias Status-quo bias Status-quo bias
How to address these biases

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