Understanding Behavioural Finance

Of all the influencing factors that will determine the success or otherwise of your wealth-building, your own behaviour is the biggest deal of all. As New Accumulators, we have some lessons to learn.

Yep, we need to talk about behaviour. If you listen to my good friend Andy Hart’s excellent Maven Money podcast, his opening line says that listening to his show will help you “behave your way to wealth, and not to misbehave your way to poverty”.

What is Behavioural Finance?

The study of how we behave relative to money is known as Behavioural Finance. The best definition I have found is from Investopedia:

“Behavioural finance is a relatively new field that seeks to combine behavioural and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.” 

Money and psychology – makes sense. Money is a deeply emotive subject, it impacts our brains like few other things, so it’s important. The blending of money and psychology is increasingly popular.

We bring a myriad of preconceptions, biases and assumptions to the table when we invest. So much so that, all the information in the world about how to invest can be rendered useless by our own behaviour. Even though we know what we should do, it’s what we actually do that counts. Here is a flavour of the kinds of behaviours we can be prone to:

Confirmation bias – we often resort to preconceived ideas when encountering something new. An investor suffering from confirmation bias will look for information that confirms his or her previously conceived position. We tend to pay more attention to information that supports our opinions, side-lining information that challenges them.

How might that manifest? If we have a view about a particular fund we want to buy or a stock we want to purchase, we look for stuff that confirms that that’s a good idea, conveniently ignoring any information that suggests that it might not be.

Anchoring – here, we use spurious information as a reference for decision-making, rather than what’s actually going on. A classic example is where we value a stock based on what we paid for it, rather than what the fundamentals show it is actually worth.

Another example might be where, as part of the financial planning process, a required growth rate is identified and investments chosen in a bid to meet that required growth rate, even if those investments are unsuitable for other reasons.

We anchor based on the growth rate we need, but actually choose to ignore some of the other stuff which might suggest that those investments are not a great idea for us.

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