Behavioural finance

It’s no surprise that interest in the area of trading psychology has spiked. Afterall, trading is an inherently challenging activity, one that evokes incredibly high levels of stress and anxiety.

And if not handled effectively, these emotions spill over into decision making processes, many times negatively.

But behaviours differ from person to person, as do the triggers or stressors resulting in impulsive outcomes. This is why research into the field of science has become so popular.

And one particular subfield of trading psychology that’s making the rounds is behavioural finance.

Behavioural finance refers to the manner in which a person’s psychology and biases effect human behaviour in the context of the financial world. It also looks at how anomalies in financial markets, e.g. unexpected volatilities, or wild price fluctuations of an asset, come about as a result of these behaviours.

In fact, so seriously is this concept being taken that even researchers in organisations like the Securities and Exchange Commission are being assigned to learn more about behavioural finance and how it is influencing financial transactions today.

Notably, the influence of biases is probably one of the most significant elements of behavioural finance. So much so that 5 sub-categories of bias are said to underly many market and trading outcomes. These include herd behaviour, emotional gap, self-attribution, mental accounting, and anchoring. Let’s explore:

When individual traders, investors or other financial practitioners mimic or copy the behaviours of a broader majority (often seen in the stock market).

When financial practitioners rely on irrelevant factors as a benchmark for guiding subsequent financial decisions.

Refers to instances when emotions or stress drive decision making, often times leading to decisions that lack logic or rationale.

Similar to emotive trading, but instead of fear or anxiety driving trading, it’s overconfidence in one’s expertise or scope of knowledge. It typically occurs if one possesses a perceived level of proficiency in a particular area, leading them to view their expertise as superior to others, even if untrue.

This is a concept that pertains to the value that different people assign to the same amount of money. It was developed by economist Richard Thaler. The concept suggests that the criteria underlying the perceived value are subjective (lacks objectivity) and may lead to adverse investments or trading outcomes.

Herd behaviour

When individual traders, investors or other financial practitioners mimic or copy the behaviours of a broader majority (often seen in the stock market).

Anchoring

When financial practitioners rely on irrelevant factors as a benchmark for guiding subsequent financial decisions.

Emotional gap

Refers to instances when emotions or stress drive decision making, often times leading to decisions that lack logic or rationale.

Self-attribution

Mental accounting

These are by no means the only biases that occur, many others have also been identified. These include confirmation bias, Experiential or recency bias, loss aversion and familiarity bias. Regardless of the bias, each one has the capacity to influence financial decision making. In the context of trading, this means putting in place effective risk management strategies to mitigate the potential of capital losses.

This will look different for everyone, depending on experience, skill, budget and goals. It may however include the adoption of stop-loss and take profit orders, the use of automated trading to reduce emotive impact on outcomes, portfolio diversification, position sizing, and more.