Three reasons why behavioural finance is so important to investors

What is behavioural finance?

You have £1,000 sitting in the bank.

You want to invest all of it in a stock.

You have a YOLO (you only live once) mindset because you’re comfortable with risk.

You see a stock you like.

The stock price is on a strong up trend.

After a tip-off from a mate, you’re convinced the price will continue to rise.

It is easy money… you hope.

You put £1,000 into “Company X”.

Then, you wait.

What are the emotions in play here?

Greed? Excitement? Fear of missing out (FOMO)? All of the above? We will get to the answers shortly. Meanwhile, back to our role play…

The stock pumps a little higher. You’re thrilled. This “sure thing” looks good.

Until it doesn’t.

It comes crashing down. It loses 20% in a single day. Another 7.5% the next day. The company reports some unexpectedly poor earnings and the market doesn’t like it.

All of a sudden, you’re sitting on a loss. All that “hopium” is now sheer panic.

Do you now cut your losses and get out of the position? Or do you wait for a possible turnaround? Things could get worse. They could also get better.

Now you’re just confused, stressed, you’ve already had enough of this investing game.

You eventually decide to cut your losses. You can’t stomach the fear of losing even more money.

However, a couple of weeks later, the company’s stock price heads higher than what you got in at.

It seems to be Sod’s Law…

However, this is an all-too-common example of investing without understanding the impact of behavioural finance.

Behavioural finance is the understanding of how different behaviours and biases impact finance or, in our case specifically, investing.

The basic concept is that, when people make investment decisions, they act on biases and influence which have a huge impact on decision-making.

Some of these biases might be overconfidence, confirmation bias, framing bias and anchoring bias.

Arguably behavioural finance is why markets experience booms and busts.

In fact, some of the biggest market downturns have been fuelled by behavioural finance, where mania and panic take over.

How is behavioural finance linked to the stock market?

Behavioural finance is etched into the stock market. You can see trails of it when you look at certain periods of stock market history.

The technology, media and telecommunications (TMT, or dotcom) bubble of the late 1990s is a prime example.

The arrival of the internet caused huge excitement in the global economy.

This fuelled speculation and hype towards internet-based companies. Equity valuations skyrocketed. This was fuelled by irrational exuberance, overconfidence, and following the crowd… with a huge dose of FOMO (fear of missing out).

Eventually, the bubble burst. And just like the hype that sent the market skyward, the fear sent it crashing down.

In fact, the Nasdaq index (a measure of the US stock market in which TMT stocks featured prominently) dropped around 76% between March 2000 and October 2022.

This tells us that markets are not rational because people are not rational.

Greed can drive share prices to artificially high levels during the good times, even if their intrinsic value is far less.

Conversely, fear and uncertainty can lead to stocks plummeting in price during bad times, even if they have strong potential.

Behavioural finance still plays a huge role in the stock market, and always will. As humans, we are emotional beings, with the ability to think and experience emotions.

Those who understand the impact of behavioural finance and can control it, stand the best chance of success.

Three ways you can use behavioural finance to invest

Firstly, only risk money that you can afford to lose.

This prevents you from getting emotionally attached to the money, making it easier for you to ride out any volatility.

You can manage rational thought more competently if there’s not so much riding on the outcome.

Imagine the emotions you’d have if you had £10 that overnight was worth £5. Not ideal, but stomachable.

Now imagine those emotions if it was £100,000 turning to £50,000. That is the same percentage loss, but with a very different emotion.

Capital allocations and risk management are ways in which you can control your behaviour in the market that might force you to act irrationally.

Investing is hard enough as it is, so you don’t need your emotions to make it even tougher for you.

Another thing you can do is to set realistic expectations and goals with a strategic plan.

You’re never going to be able to perfectly time the market.

So, don’t try.

If you want to invest for the long term, then invest for the long term. Find the stocks you want to hold for 10, 20, 30 years, assess your capital allocations and set the plan in motion.

Don’t expect that all your stocks will win. Some will lose. Some won’t perform as expected, some will exceed your expectations. Nothing will go perfectly to plan. So don’t expect it will.

But with a realistic set of expectations and a plan, when the emotions get wild, you have a point of reference to come back to.

Also by dollar-cost averaging into positions over time, you can smooth out volatility. Add this as part of your plan and you can remove a lot of the worry of market swings higher and lower.

By not trying to be perfect, and being realistic, you can remove a lot of the behaviours that get investors into so much trouble.

Finally, prioritise facts over personal biases. In the long run, facts beat perceptions hands down.

Given poor economic conditions and fundamentals (such as revenue, profits, commercial contracts, etc), is the company really likely to head higher because your mate from the pub thinks it is?

Probably not.

Ask yourself, what does the data suggest? Look at things like the market size, the competitors in an industry, the unique aspects of the company you want to invest in.

Then think about how the company can achieve their goals. Does it have the money to do it? Is the company making money to fund it? Will it need capital to fund it? Has it hit previous milestones? Is there consistent deal flow?

Yes, investing is a game of probabilities, but you need to look at the evidence over personal biases or “feelings” to give yourself the best chance.

But to be fair, just recognising that behavioural finance is important is the biggest thing to consider. By recognising its influence and impact, you’re already a step ahead of most investors.

Get to know different biases and ask yourself if they’re impacting your decision-making. Sometimes, a bias can be useful, sometimes it will work against you.

But simply understanding they exist and knowing how to manage them is the best way you can use behavioural finance to your advantage.

Until next time,

Sam Volkering and Elliott Playle
Exponential Investor