The subject of behavioural finance is one that has been in the press recently and it is one I am particularly interested in, but what does it mean?
Essentially, it is the crossover between investing and the sub-conscious psychology that forms the basis for an investor’s rationale.
The subject can generally be broken down into 8 recognised concepts;
- Prospect Theory & Loss Aversion
- Mental Accounting
- Confirmation and Hindsight bias
- Gambler's Fallacy
- Herd behaviour
I will choose two to look at in this blog.
Ask yourself the following. Would you rather have;
A) A guaranteed payment of £90 or
B) A 90% chance of receiving £100
Then ask yourself this, would you rather have;
A) A guaranteed loss of £90 or
B) A 90% chance of losing £100
This principle suggests that if investors are faced with the possibility of losing money, they often take riskier decisions aimed at loss aversion. Did you choose the same as the majority; answering A and then B? The two questions above are mirrors of each other, but most people would answer A for the first and B for the second, thus proving the theory.
This is the lack of understanding that results in incorrect assumptions and predictions about the onset of events.
For example; in the Monte Carlo casino in 1913 the ball of a roulette wheel fell on black 25 times in a row. Many gamblers thought this an excellent opportunity to bet on red. However, the next spin was black and millions were lost. If an investor thought about it logically; on every single spin, there is an equal chance of the ball falling on red or black. On this occasion, they were therefore falling into the gambler's fallacy trap and not thinking clearly.
I find this a very interesting topic and one that I have done quite a bit of reading on. If you, like me, found this interesting, I would recommend reading “Thinking Fast & Slow” by Daniel Kahneman. Hopefully, your good investment behaviour will lead to good investments!