Why some behaviours could make you less wealthy

From overconfidence and loss aversion to herd behaviour and confirmation bias, with a better understanding of financial behaviours you could make more balanced decisions about your money and stay focused on investing wisely.

Influences in your psychology may be behind some of your financial habits and decisions, without you being aware of it.

What is behavioural finance?

Behavioural finance is the study of the influence of psychology on financial decision making. It helps explain why investors often appear to lack self-control, are not always rational and could make decisions that are influenced by their own biases.

Even the most experienced investors can make poor investment decisions based on beliefs about the financial markets or because of emotional reactions to the latest developments.

Common behavioural biases

Here are four of the main psychological biases related to behavioural finance:

1. Overconfidence

This can cause a real problem for investors who mistake luck for skill. If you make a successful investment decision you might believe that your hot streak will continue because you feel you’ve cracked the code to beat the market. But this overconfidence and illusion of control over your investments can be dangerous. It could lead to taking bigger risks and increase your chances of actually losing large amounts of money.

2. Loss aversion

When you worry about losses, you tend to focus on trying to avoid a loss rather than making a gain. That’s because psychologically, you feel the pain from losses more intensely than the idea of potential gains. The fear of loss can often make people unsure of when to invest, what direction they should choose and how long they should take to ride out fluctuations in the market. It could also lead to holding on to investments for too long after they have fallen in value in the hope they will recover.

3. Herd behaviour

You’re probably familiar with the idea of ‘following the herd’. In investment terms, this can happen when investors get swept up in the euphoria of an investment that keeps going up and everybody seems to be buying into it. Unfortunately, by the time the crowd hears about the opportunity, it can often be too late as most of the gains may have already been made. There are plenty of examples in history when herd behaviour has been behind a speculative frenzy in the stock market, a famous one being the dotcom bubble of the late 1990s.

4. Confirmation bias

This is the tendency to seek out information that confirms our existing beliefs. For example, an investor may only read news stories that are positive about a particular share, while ignoring any negative ones. This behaviour could lead to an inaccurate understanding of the company and its prospects, resulting in poor investment decisions.

5. The sunk cost fallacy

Have you ever gone to a restaurant and over-ordered food, then eaten everything to "get your money's worth" even though you're no longer hungry? That describes the concept of the sunk cost fallacy. This term describes when you continue with something you've invested money, effort or time into, even if the costs outweigh the benefits. The phrase "throwing good money after bad" is valid here.

These biases show how important it is to try to keep your emotions in check as they could distort your ability to make rational decisions. However, it’s easy to be led by your emotions at times, especially if stock markets are volatile. You could, for example, make an investment decision based on fear or greed, rather than rational analysis.

That’s why seeking some advice and input from an expert is a good way to approach your financial decision making. When it comes to investing, an objective point of view could help you create a plan that is right for you.

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