Behavioural finance: understanding the psychology behind investing

Behavioural finance looks beyond numbers and charts to see how emotion affects stock markets.

In the past, traditional financial theories (like the efficient market hypothesis) assumed that the prices of stocks and shares were only affected by news and data, so they were always correct based on the information that was available.

But these older ways of studying investing didn’t factor in that people make emotional decisions. That can cause share prices to swing up and down more than they should, if they were just based on information like company performance.  

Here are some common personal biases that can affect you when you're investing.

Overconfidence

Feeling like you have all the answers can make you take big risks if you’re investing shares, because you think you can spot winning stocks easily. It’s easy to become overconfident if you’ve bought or sold shares and made a profit, when it could be down to being lucky. 

Loss aversion

As humans, we’re wired to protect ourselves against loss. This means the negative feeling of losing £1000 on your investment hits much harder than the good feeling if the same investment gains by £1000. This reaction to losing money can cause you to sell your investments when the overall market is falling, or hold onto individual shares you’ve bought that are performing poorly in the hope you’ll claw back losses.

Herd mentality

Following the crowd can mean copying other investors even if we don’t understand what or why they’re buying or selling. We can assume a large group of people doing something must be correct. For example, this can mean rushing to buy a tech stock you've read that's doing well, without checking out the business for ourselves. Or taking tips from friends.

Confirmation bias

This involves paying attention only to news that supports what we already think. For example, believing a stock you own is great and ignoring warning signs. This can lead to a rude awakening when it drops in value

Recency bias

This is where you’re more likely to think that recent events or prices are all that matter. After a big rise in the stock market, you could decide that will continue forever and commit too much of your money to investing. After a crash, you might think it will keep falling and lose faith in investing. We tend to give too much importance to the most recent news or trends rather than looking further back in time to see the bigger picture.

The way biases work can be seen in bigger market events. Being aware of these situations like these can help you think, before acting on impulse.

Panic selling

When markets drop, like in March 2020 during the Covid crash, fear or losing money – described in behaviourial science as loss aversion – caused large numbers of people to sell in a panic. This rush to cash your money out can mean you take an initial loss and then, as with the market through Covid, miss out when it recovers as you’re not reinvested in time.

Fear and greed

We saw how FOMO (the fear of missing out) can play out in 2021. During the ‘meme stock’ craze, many people bought shares in companies because lots of other people were, triggering FOMO. This herd mentality pushed prices higher for a while. But when the bubble burst and prices dropped, many people were left with shares worth far less than they’d paid.

Hot-hand fallacy

This recency bias is like thinking a winning streak will never end. For instance, a gambler wins a few bets and keeps betting bigger, or an investor sees a stock go up and thinks it will keep rising. We saw an example of this in the late 1990s with the dotcom tech bubble. Investors saw dotcom stocks shoot up in price month after month - even companies with no profits. People believed that because these stocks had been rising so quickly, they would keep rising. But the bubble burst and many of these companies went bust leaving investors with big losses. 

Spotting and managing your biases can be the key to a solid long-term investment strategy. Here are some tips to help manage your emotions and make more rational decisions.

Set clear long-term goals

Write down what you are saving for (for example, a house, holidays or retirement) and when you need to get there. Having a clear goal and timeframe can help you stay focused and not panic when markets swing up and down.

Consider diversification

Some investors choose to spread their money across different types of assets (like stocks from different companies, bonds, or property funds) so they’re not risking it all on one investment. This is called diversification. An example would to use funds that track a stock market index, like the FTSE 100, or managed funds where experts pick a mix of investments for you.

Consider automated investing

Another method some investors use is setting up a regular fixed payment into your investment account every month. This could also help you to avoid trying to time when to put money in, based on how you’re feeling. If the markets are up, you keep investing and if they’re down, you keep investing. This is called pound-cost averaging, and it works to smooth out those ups and downs over the years. 

Consider advice

If you feel unsure about your investing strategy, rather than going by gut feeling, you can talk to an independent financial adviser. They can give you personalised advice based on your goals. The government’s MoneyHelper service can help you find an adviser.

Don’t review too often

It's important to review your investments to make sure they still fit your goals – for example, every six months or annually. But try to avoid checking them every time you read financial news or out of habit on your investing app – seeing the value go up and down in the short term can cause you stress and may lead you to make snap decisions. It’s best to trust in your long-term plan. 

As you start investing, building good habits can help you stay on track:

Be patient

Remember that investing is for the long-term. Prices go up and down every day, but over years markets tend to rise. Don’t panic every time your stocks dip a little. Give them time to grow.

Reflect on your decisions

Keep notes or a simple diary of your big choices. For example, write down why you bought or sold something. This can help you spot whether you are trading using emotion or information.

Don’t react to every bit of news

It’s good to learn about markets and the economy but following the news too closely can make you anxious and lead to rushed decisions.

Stick to your plan

Set rules for yourself (like a target saving amount or date) and try not to change them for every headline. Good habits, like saving regularly and reviewing goals each year, will keep you on track even when times are tricky.

Celebrate your milestones

Notice when your investments reach key values as proof your logical strategy is working. Over time, you’ll feel more confident as you see your money grow.

In the long run, keeping a calm, steady approach and learning from experience can help you become a more confident investor. By not giving in to emotion and focusing on your goals, you’ll be ready to stay the course through ups and downs in the market.