Traditional finance theory starts from the principle that markets and their investors are perfectly rational. Yet a closer look reveals this is optimistic.
Behavioural finance studies the impact of investor psychology on financial decisions. It has developed in response to the inconsistencies between rational theory and irrational reality. People can act in surprising ways. For instance, you might recognise these behavioural biases in
yourself or others.
Overconfidence: Many people when asked identify as ‘above average’, whether in terms of driving ability, intelligence or looks. By definition it cannot be true – no more than 50% can be above average. Overconfident investors can pay a high price to learn this truth.
Herding: “Everybody is investing in technology/emerging markets/commercial property/etc., so I will too.” It seems the easy option: human beings are inherently fearful of going against the crowd. However, the crowd’s judgement is not always right.
Confirmation bias: Which do you pay more attention to: the information and comments that reinforce your views or those that contradict them? The natural response is the former, but when it comes to investment, hearing only what you want to hear could mean ignoring important, if uncomfortable, truths.
An understanding of behavioural finance ideas can help you identify your own biases. The nearer you come to acting like a rational investor, the more you may be able to benefit from the irrationality of others.
The value of your investment, and any income from it, can go down as well as up and you may not get back the full amount you invested.
Past performance is not a reliable indicator of future performance.