Behavioural Finance and Its Impact On Your ROI

Behavioural finance and behavioural economics are the same things.

Why do people refuse to withdraw money out of their savings account when they are drowning in debt?

Photo by Jason Leung on Unsplash

How is it that we treat the same cash with a different point of view at times? Why do you treat your tax return as a windfall and your inherited money as something you shouldn’t touch for as long as possible? Why do we opt-in for an ultra-low returns savings account for our kids when we have the choice to invest that money with relatively low risk?

Behavioural finance

It’s a study of the physiological influence on our financial decisions. Behavioural biases often lead people to make bad or downright wrong decisions at times. Understanding these biases can help us make better and informed decisions.

This area of study focuses on doing experiments to help us understand something wrong. Still, most of the general population agrees on it. But it goes even further that by explaining how hard it can be to get rid of those flaws, even if you understand the issue at play.

This field of study rose in the late 1970s in response to the EMH (Efficient Market Hypothesis). EMH states that all the required information regarding a stock is already accounted for in the stock price. Therefore no one can ‘beat the market’, and there is no point in searching for undervalued stocks. (Will write on this in detail in future.)

There are four main concepts to the study of behavioural finance.

  1. Mental accounting
  2. Herd mentality.
  3. Anchoring
  4. Higher self-rating

Let’s take a deeper dive into what these four main concepts tell us about our behaviour.

Mental Accounting –

According to the professor of economics at the University of Chicago, mental accounting is the set of cognitive operations used by an individual or a household to keep track of and organise their financial activities. Underlying this theory is the concept of the fungibility of money. The idea of fungibility is that all money is the same regardless of its origin and intended use. To avoid the mental accounting trap, individuals should treat money as a fungible resource.

People often allocate money to different categories; for example, a refund from ATO or IRS is treated as found money, and people treat it like they have to spend it. In comparison, people save money in their holiday accounts while maxing out their credit cards in everyday use.

Mental accounting often leads investors to make irrational decisions. Using Richard Thaler’s example. An investor who owns two stocks, one with paper gain and another with paper loss. The investor needs to raise cash and must sell one of the stocks. Mental accounting is biased towards selling the winning stock even though selling the loser is the rational choice as it helps with tax efficiency and the fact that the losing stock is a weak investment. The pain of realising a loss is too much to bear for the investor. So the investor sells the winning stock to avoid that pain. The loss eversion leads investors astray with their decisions.

Herd Mentality —

We human beings are a social bunch. Since the beginning of time, we have lived in groups. If we are not sure about something, we look at others, and if others are doing the same thing as you, you get that sense so comfort. That is a herd mentality, in essence. To put it in an economic context, herd mentality is when an investor buys a stock just because everyone around is buying that stock. Just because everyone is buying that stock doesn’t mean everyone else has researched the company.

For example, there are two Italian restaurants (with an exact number of tables and chairs per restaurant) right next to each other on Lygon Street in Carlton. One restaurant is packed with diners with only a few tables available far in the corner next to the washrooms, and the other restaurant is completely empty. You go out to dinner. Which one would you choose to dine in? Of course, you are the busy one with no regard for the quality of the food, place or dining experience. As you rationalise, the busy place must be serving quality food, and they’re clearly doing something better than the guys next door.

In financial markets, the Herd mentality has caused many catastrophes, including The Global Financial Crisis in 08 and The DoTCom crash, to name a few. In the late 90s, most investors, retail and institutional, loaded up on any company based on this new internet thingy. They failed to look for the indicators before making their decisions. Soon after that, the growth halted, and investors started pulling their money out of the companies and began the domino effect, Which we now know as the DotCom crash.

Anchoring Biases —

Anchoring bias is one of the more advanced biases out there. Even professional investors and money managers suffer from it. The main issue with bias is that it is hard to determine if investors make decisions based on facts and figures or if the anchoring bias influences their behaviour.

For example — Why do you think sales go through the roof on Black Friday and Boxing Day? When you go to the supermarket and see the price of your favourite shoes go down from $250 to $150, whooping 40% discount, you rush to buy those shoes. Anchoring bias can help you explain this phenomenon. When you see the price of shoes marked at $150 with no discount, you tend to think it is too expensive, but you see the price of $250 now with $150 on the tag. That figure gives you the base to compare the two prices. That is anchoring bias at work.

In the financial context, Anchoring bias influences investors to look at the company’s past performance and assume that the future will be just like the past. In 2005–07, anyone and everyone was buying property, and banks were giving out NINJA loans (No Income, No Job & Assets) to prop up the housing market and making fat profits. We all know how did that turn out to be! Most investors looked at the booming housing price and loaded up on mortgages thinking the price would go up even higher, and we’ll flip it later for a profit.

Higher self-rating —

In physiology, a higher self-rating is a common emotional bias, in which an individual takes all the credit for their success. And give little to no credit to other individuals or any other external factors. Higher self-rating can impact investors negatively and hurt their long term return prospects.

A typical example of higher self-rating bias is when most investors consider themselves above average. Mathematically, it is impossible to be above average when most investors consider themselves in the above-average category.

We can do a few things to give us a handle on behavioural biases.

  1. Manage your emotions — when buying a stock, invest your money, not your emotions, let the grass grow and cut the weed. Let your winners compound and cut your losses short and move on.
  2. Seek contrary opinion — If you feel strongly bullish on a particular investment. It’ll be wise to listen to someone who is bearish on the same asset. It’ll help you see the other side of the spectrum and potentially help you with better decision making.
  3. Don’t chase past winners — Don’t be overly attached to any asset. If it stops serving its purpose, get rid of it. And move to something more closely aligned with your investment objectives.
  4. Pay more attention to the detailed analysis than the story. When deciding whether to invest in an asset, don’t listen to the news as your primary source of research. Look at the in-depth analysis of the company and decide whether it suits your style of investment. A company may have a great buying opportunity at its all-time high price in the inflated market. What if the news is for the day-traders. They don’t care about historical prices and inflation or interest rates. They only care about the company’s stock for the next few hours or days. Whereas you may be searching for investment into your retirement account. BE CAREFUL ABOUT THE GAME YOU’RE PLAYING.

Be fearful when others are greedy and be greedy when others are fearful — Warren Buffet.

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