By Peet Serfontein
Financial decision making is often assumed to be a rational process grounded in logic and objective analysis. Classical economic theories are based on the notion that individuals act in their own best interest, optimising outcomes based on available information. However, real-world observations frequently challenge this assumption. People often make irrational choices influenced by emotions and bias.
Behavioural finance is a field of study that combines insights from psychology and economics to understand how psychological influences and biases affect behaviour. It challenges the traditional assumption of rational market participants and offers explanations for anomalies such as bubbles, crashes, and persistent mispricing.
Key concepts within the behavioural finance framework include:
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Heuristics: Heuristics are mental shortcuts or "rules of thumb" that individuals use to make complex decision-making more manageable. Rather than engaging in detailed analysis, people often rely on these simplified strategies to arrive at quick judgements, especially when they are uncertain or under time pressure. While heuristics can be useful in speeding up decisions, they can also lead to errors. For example, investors might judge the risk of an investment based on similar past events, rather than new evidence.
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Biases: Biases refer to consistent and predictable deviations from rational judgement or decision-making. These cognitive distortions can result in flawed financial decisions, such as underestimating risks, overvaluing certain investments, or ignoring contradictory information. Biases are not random - they follow patterns that can be studied and anticipated. Common financial biases include overconfidence, anchoring, and loss aversion. Recognising these patterns can help individuals and professionals avoid costly mistakes in financial planning and investing.
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Emotions: Emotions play a significant role in financial decisions by shaping how individuals perceive risk, reward and time. For instance, fear can lead to panic selling during a market downturn, while excitement might drive excessive risk-taking in a bullish market. Emotional responses often override rational analysis, leading to decisions that prioritise short-term comfort over long-term benefit. Managing emotional responses—through mindfulness or rules-based investing—can help maintain more consistent and disciplined financial behaviour.
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Social factors: Social influences, such as herd behaviour and peer pressure, significantly affect financial choices. Individuals often look to the actions of others for cues, especially in uncertain situations that can lead to collective movements like market bubbles or crashes. For example, if many people are investing in a particular share, others may follow suit without conducting their own analysis, assuming the group cannot be wrong. Social validation, media influence and trends can distort individual judgement and amplify market volatility.
Common behavioural biases
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Overconfidence: refers to an individual's overestimation of their own abilities, knowledge or control over events. In finance, this can lead to excessive trading, underestimation of risks and poor diversification. For example, retail investors who consistently believe they can "beat the market" may trade too frequently, incurring high transaction costs and subpar returns.
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Anchoring: Anchoring occurs when individuals rely too heavily on an initial piece of information (the "anchor") when making decisions, even if it is no longer relevant or arbitrary. For example, an investor might fixate on the historical high of a share price and refuse to sell below that point, even if the fundamentals have changed.
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Loss aversion: Loss aversion is the tendency for people to prefer avoiding losses rather than acquiring equivalent gains. According to prospect theory, losses are felt more acutely than gains of the same magnitude. For instance, an investor may hold on to a losing share in the hope it will rebound, rather than realising the loss and reinvesting in a better asset.
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Herd behaviour: Occurs when individuals mimic the actions of a larger group, regardless of their own beliefs or analysis. It often leads to bubbles and crashes. For example, in a market rally, investors may buy assets simply because others are doing so, not because the asset is fundamentally sound (e.g., the dot-com bubble).
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Confirmation bias: The tendency to seek out or give more weight to information that confirms existing beliefs while disregarding contradictory evidence. For instance, a bullish investor might only read positive news about the economy and ignore warning signs of an impending downturn.
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Mental accounting: The tendency to treat money differently depending on its source or intended use, rather than viewing it as fungible. For example, someone may be willing to splurge a tax refund (a "windfall") but be extremely frugal with their salary, even though both are part of the same financial pool.
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Availability bias: Overestimating the importance or likelihood of events that are recent, memorable, or emotionally charged. For instance, after hearing about a share market crash, an investor may become overly risk-averse, even if long-term data supports continued investing.
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Recency bias: Closely related to availability bias, recency bias is the tendency to place too much emphasis on recent events when making decisions. For example, investors may assume that a share that has performed well in the last few months will continue to do so, ignoring long-term trends, valuation, or cyclical risks.
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Status quo bias: A preference for things to remain the same, leading to inertia and resistance to change. For instance, investors may stick with poorly performing funds simply because they are used to them or feel uncomfortable switching providers.
Consequences of behavioural biases
Behavioural biases can have significant and wide-ranging consequences in both personal and institutional financial contexts:
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Individual level: Poor investment choices, failure to plan for retirement, inadequate risk management, excessive debt and suboptimal savings behaviours.
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Biases: Mispricing of assets, volatility, formation of speculative bubbles and subsequent crashes.
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Emotions: Ineffective policy implementation if behavioural responses are not accounted for, such as under-enrolment in pension schemes despite tax advantages.
Mitigating the impact of behavioural biases
While it is difficult to eliminate biases entirely, several strategies can help individuals and institutions manage their effects:
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Education and awareness: Understanding the nature of bias is the first step toward mitigating them. Financial literacy initiatives can help people recognise their own vulnerabilities.
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Use of checklists and rules-based approaches: Creating structured decision-making frameworks can reduce reliance on emotional or intuitive reactions. For example, investment policies with pre-set asset allocation rules can prevent panic selling during downturns.
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Diversification: A well-diversified portfolio helps mitigate the impact of biases like overconfidence and loss aversion by reducing overall portfolio risk.
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Automation: Using automated systems (like robo-advisors, automatic pension enrolment) can reduce the effect of inertia and status quo bias.
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Seeking independent advice: Working with financial advisers or using peer-reviewed financial products can provide objectivity and counteract individual biases.
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Behavioural nudges: Employing "nudges" - subtle changes in how choices are presented - can encourage better financial behaviour. For example, opt-out pension schemes have significantly improved enrolment rates in the United Kingdom.
