Behavioural finance is a portion of financial theory which attempts to provide reasoning for the irrationality of investors in the financial markets and, because of this, why markets are not entirely efficient. This irrationality is usually defined as either resulting from information processing errors or from innate behavioural biases. This article will explore some of the major arguments evidencing irrationality as well as their applications to the financial markets.

There is an endless list of factors that could be considered under the umbrella of behavioural finance. The key assumption of this subject matter is that investors are ‘human’ and are thus prone to irrational behaviour due to their human instincts. Consequently, much of behavioural finance overlaps and can directly contribute to each other.

Information Processing Errors

In all walks of life, people tend to overestimate their ability, and this is certainly present in the world of finance. Overconfidence of investors is an example of an information processing error and can have enormous consequences on the performance of investments. Fund managers and investors often believe they know better than the markets and that they can make significant profits due to their own ingenuity. When this goes well, they reap the rewards of their investment decision. However, overconfidence can work to their own demise too. Investors may not fully account for the associated risk of an investment whilst fund managers could ignore crucial analysis from their peers which turns out to be correct. This could lead to overexposure to loss-making investments and hugely impact the returns of the position.

In the fund management space, it could be argued that the decision between active or passive fund management derives from investors thinking they can outperform the market. Research suggests that active fund managers are just overconfident in their ability, with only a third of active equity funds outperforming their passive counterpart. This goes to show how a fund manager’s excessive confidence in themselves can ultimately lead to poorer performance for the client.

Another information processing issue of investors is forecasting errors. This is where investors overly weight more recent information compared to previous news and thus make more extreme investment decisions. These misestimations can have knock-on effects across portfolios and result in more losses or less profits. It is useful to note here that the overconfidence of investors can directly contribute to these forecasting errors and have a magnified effect.

A final information processing issue facing investors would be that of excessive conservatism. This implies that investors can often be slow in reacting to new developments in the market and adjusting their holdings accordingly. No investor is looking to lose money and so a degree of conservatism is to be expected. Having said that, being overly cautious can really impact the returns of a given portfolio. It is integral for investors to have the correct degree of cautiousness as per their risk tolerance level to maximise their return potential.

Behavioural Biases

Behavioural biases provide an insight into how investors, even if they were perfect at processing information, still make less-than-fully rational decisions.
The first example of this could be ‘regret avoidance’. This is the idea that an investor deviates from rational decision making as a result of a position entered going against them. For example, an investor enters a position that soon incurs a loss. Rationality would suggest that the investor should liquidate the investment as it is having a negative effect on portfolio performance. However, the investor may actually choose to hold on to the losing position or to buy more of it in the hope that its value rebounds and starts to increase. Whilst this would be a clever move if the security did indeed rebound, a continuation of this downward spiral means the small loss that a rational investor would have made has now turned into an even greater loss – all because the irrational investor wanted to avoid regret. Preventing regret avoidance is all about an investor’s ability to execute their investment strategy regardless of how they may feel about it.

Herd mentality bias is an ever-present example of a behavioural bias within financial markets. This is where investors tend to copy what each other are doing, particularly in times of market volatility and uncertainty. When this happens, often an investor’s own analysis is disregarded by themselves as they look to others in the market for guidance. The buzz around herd mentality can create such hysteria in the market that everyone feels the need to do the same thing – this is often what happens when asset bubbles finally pop.   Links can be made here to regret avoidance, whereby potentially some investors want to prevent feeling regretful about their investment decision by following someone else. This further highlights the forementioned interconnectivity of behavioural finance.

The Future

Whilst human irrationality and decision making will always be present in the financial markets, there are some new developments that may depress some of the behavioural finance issues which lead to sub-optimal performance. Firstly, the increased implementation of quantitative approaches to investing can create a more objective view towards the decision-making process. By decreasing the scope for human error as a result of information processing issues or behavioural biases, returns can approach the optimal level. The speed of Artificial Intelligence (AI) within the financial sector will also look to decrease the likelihood of conservatism, as technology is able to work in a fraction of the time compared to investors alone.
Overall, the future is all about removing as much subjectivity as possible in the investment process whereby downside risk is limited, but upwards potential is infinite. It is and will continue to be, a complex challenge.

In conclusion, behavioural finance offers an insight into why financial markets are not as efficient as some would expect. The combination of human instinct, as well as innate biases, provide an explanation as to why decisions made are not entirely rational. With that said, it will be interesting to see how information processing errors and behavioural biases change as time goes on and innovation in the financial sector flourishes.

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