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Behavioral finance: the role of emotions in investment

We are all subject to emotions, positive or negative, which are the result of a multitude of factors, such as our beliefs, our experience, our world view, or our personality.
Finance is all too often equated with rational information such as probabilities, statistics and other predictions that are based on numbers. But while all this data is useful and should in theory guide investors to make purely logical decisions, it is not uncommon to make errors of judgement based on emotion.

What is behavioural finance?

Behavioural finance, which emerged some 30 years ago, is the study of the various psychological factors that can affect financial markets.
During the 1970s and 1980s, psychologists Daniel Kahneman and Amos Tversky, assisted by economist Robert J. Shiller, conducted several studies on how the financial market is affected by the emotions and subconscious of its investors. This study, innovative for its time, however, went against the historically established assumption of "efficient financial markets", which held that they were subject only to rationality and predictability.

Introduction to behavioural finance

How to resist biases?

Once you understand that your emotions can influence your financial decisions, it is easier to step back and take an objective view. By identifying the most common behavioural biases, you can optimise your investments and not succumb to emotional pressures that may impair your judgement.

  • Confirmation bias occurs when a person seeks information on a specific issue, but focuses on information that will confirm their already formed belief.

    • In everyday life :

    You want to go to your dream destination at a certain time and look on the internet to see if it is the right season, but initial results show that other times are better. People with confirmation bias will tend to discard information contrary to their basic idea, even if it is in the majority, to avoid having to change the date or destination - and will instead continue searching until they have accumulated enough information to confirm their hypothesis.

    • In our investment decisions :

    A potential investor, looking to explore investment ideas but convinced that stocks are very risky investments that will inevitably lead to large losses, will only retain information related to previous crashes or downturns and take every article on the subject as confirmation that he or she should not invest (yet). Conversely, someone who is looking for a reason to invest in a particular company that they are passionate about, for example because they have read articles in the press that have piqued their interest, will only take positive information about it to justify their investment.

  • Anchoring bias arises when the investor is aware of initial information and interprets any new information in relation to it.

    • In everyday life :

    An experiment conducted in the late 1990s in the United States is often used to illustrate anchoring bias: the blue whale question1. A group of individuals is split into two subgroups, A and B. In group A, the researchers asked the question: "Is a blue whale longer than 49 metres, and in your opinion, how long? Group B was simply asked, "How tall is a blue whale? The average answer for Group A, which the researchers had anchored on the 49-metre information, was 60 metres, while the average for Group B was only ... 30 metres. This illustrates perfectly the strength of the anchoring effect on our judgement. (actual length of a blue whale: 26 metres on average)

    • In our investment decisions :

    An example of anchoring bias is decisions based on the past performance of an investment. For example, an investor, having read that the share price of a company he is fascinated by rose last year, will then find shortcuts to reinforce his idea: if the share was up last year, it should be up again this year. Hence the importance of taking seriously the regulatory statement that past performance is not a guide to future performance! And look for reasons in favour of an investment also in its current situation and future market prospects.

    1Strack, Fritz, Mussweiler, Thomas. Explaining the enigmatic anchoring effect : Mechanisms of selective accessibility. Journal of Personality and social psychology, 1997

  • Repetition bias is the tendency to attribute more credibility to frequently repeated information.

    • In everyday life :

    Do you think you are more likely to be killed by a shark attack or an asteroid strike? According to the results of a University of Florida study2, you have a 1 in 3.7 million chance of being killed by a shark, but more than twice as high (1 in 1.6 million) of dying by an asteroid fall. So why the shark phobia? Quite simply because the fear of sharks has been widely promoted in books and films - everyone remembers the famous "Jaws" - and shark attacks are widely reported in the media.

    • In our investment decisions : 

    Take the example of stock market crashes: those of 2001, 2008 and more recently the market downturn in 2022 are widely reported in the press, as is the dramatic surge and fall in cryptocurrency prices during the years 2020 - 20223. We are thus easily led to assume that this type of extreme event is very common and could occur unexpectedly at any time with devastating effect on our economies.

    2https://fr.euronews.com/2017/06/26/quelles-sont-vos-chances-detre-tue-par-un-requin

    3https://www.lafinancepourtous.com/2022/01/24/comment-peut-on-expliquer-la-baisse-des-cours-du-bitcoin/ ; https://fr.statista.com/infographie/23669/evolution-du-cours-du-bitcoin-prix/

  • This bias consists of the tendency to want to act in difficult times; because activity has a reassuring effect on our mind when we feel under stress.

    • In everyday life : 

    You return to the office after a few weeks' holiday and have a list of files to deal with that is as long as your arm. Do you tend to (a) deliberately and calmly focus on certain core files, or (b) do you first try to parcel out a large number of tasks to reassure yourself that you are making progress on as many files as possible? If you identify more with option (b), then you may tend to make some decisions under the influence of activity bias.

    • In our investment decisions : 

    In times of stress or when the market is falling, it is not uncommon for investors to succumb to activity bias: they will seek to diversify their positions as much as possible and make multiple purchases and sales in order to feel safe. But these hasty decisions, made under pressure, are rarely based on a set strategy and can therefore be detrimental to your portfolio.

  • Risk aversion can have a paralysing effect: the person seeks to avoid any risk that is considered too high. It is true that one should not take unnecessary risks, but too much risk aversion will prevent the investor from implementing a strategy that can be successful for his or her assets. 

    • In everyday life : 

    In the lottery, would you rather have (a) a 100% chance of winning €100, or (b) a 50% chance of winning either €200 or nothing? You will have guessed that a person who is susceptible to risk aversion bias will probably choose option (b), not being able to bear the possibility of taking the risk inherent in option (a). 

    • In our investment decisions :

    You want to prepare for your retirement in about 20 years' time, and your advisor suggests two options: (a) to invest your savings in a strategy that has a potential return of 2% per annum, and logically with a relatively low risk of loss; or (b) a solution that could return up to 10% per annum, but which has a higher risk of loss Although it will certainly be explained to you that the longer your investment horizon - in this case 20 years! - the lower the risk of loss on so-called 'risky' investments such as equities, if you are highly risk averse then you will probably tend to choose option (a) for the sense of security it provides. Knowing that choosing is giving up, you will have to give up on any potential to increase the value of your savings beyond the low rate presented by option (a). 

  • The fear of failure is something we all know. However, the disposition effect is when our natural tendency to avoid failure distorts our ability to judge. 

    • In everyday life : 

    You are at the casino, have bet 50 euros on a game but unfortunately lost the bet. You might decide to call it a day and go home. On the other hand, the disposition bias might lead you to try your luck again and not be stuck with a loss - taking the risk of making a 2nd loss. 

    • In our investment decisions : 

    When we see that an investment we have made has been losing value for some time, we may tend not to part with it and hold on to it in the hope that it will go back up, or even strengthen our position in the belief that we will benefit from the current lower purchase price. We say "not sold, not lost", but often behind this reaction lies the desire not to question our original decision. Even if it means adopting a particularly risky attitude that could prove catastrophic for our portfolio...
    Admitting defeat is not easy, but condition your investment decisions on the change in fundamentals: if the reasons you invested in the investment in question are still there, there is no reason to sell; conversely, if you consider that the favourable long-term conditions are no longer present, then a sale is probably the wisest decision to cut your losses. 

  • Being confident in one's strategy is a good thing, but overestimating one's abilities can be detrimental in life as well as in finance! 

    • In everyday life : 

    When a researcher in the 1980s asked a panel of American drivers if they considered themselves to be in the top 50% of the driving population, 93% said yes.4 Since this is statistically impossible, it is the overconfidence bias that is at work, leading a large proportion of the participants to overestimate their skills.

    • In our investment decisions : 

    Especially when investing is an area we are interested in or even passionate about, we may tend to imagine that we are sometimes particularly good at "feeling" the market ... which can lead us to trust our supposed flair more than objective data analysis. For professional investors, moreover, the picture is not much different: in a 2006 survey of 300 professional fund managers5, asking them if they thought they were above average in their expertise, 74% of fund managers said yes, and of the remaining 26%, most thought they were average. Hardly anyone thought they were weaker than average...

    4Source : Harvard Business Review, 2019 https://www.hbrfrance.fr/chroniques-experts/2019/10/28301-les-6-biais-qui-impactent-le-plus-vos-decisions/ & Department of Psychology, University of Stockholm, Sweden, study by Ola Svenson (Feb. 1981)

    5https://www.morningstar.co.uk/uk/news/221781/is-overconfidence-ruining-your-returns.aspx & https://papers.ssrn.com/sol3/papers.cfm?abstract_id=890563

  • The herding effect, or group effect, is a term that first appeared in studies conducted in 1971 by the psychologist Irving Janis6. This bias occurs when we trust the judgment of the majority, or at least those around us, more than our own. This paradoxical phenomenon is due to the fact that each individual tries to conform his or her opinion to what he or she believes is the consensus opinion of the group. 

    • In everyday life : 

    On holiday, you are looking for a restaurant to have lunch. Will you choose a restaurant solely on the basis of the menu and whether you like the place, or will you rather choose one where you already see a lot of people at the table? 
    We agree that in many cases the majority may well be leaning in a certain direction for good reasons. However, it is also essential to value your own judgement, which allows you to act according to your own priorities. 

    • In our investment decisions : 

    Apart from decisions that one may regret about a choice of restaurant or a brand of car, groupthink can also lead to totally irrational decisions in the markets, such as the famous speculative bubbles. 
    One of the first speculative bubbles in history was the famous tulip crisis in 17th century Holland7. A sudden craze for bulbs, reinforced by additional demand from France in 1634, fuelled price rises, and speculators smelled a bonanza, and at the height of the tulip craze in February 1637 promises to sell a bulb were negotiated for an amount equal to ten times the annual salary of a skilled craftsman. However, as soon as tulip sellers found it difficult to find buyers for the increasingly exorbitantly priced bulbs, the trend was reversed: as the market weakened, demand collapsed, causing prices to fall.
    In the digital age, the herd effect can quickly take on great proportions. This was seen in 2021 with Gamestop's share price increasing more than tenfold in a few months, as the actions of a senior trader triggered a snowball effect on the Reddit forum, creating a speculative bubble that burst as quickly as it appeared. 

    6https://www.psychologytoday.com/us/basics/groupthink

    7https://fr.wikipedia.org/wiki/Tulipomanie

To conclude

There are many biases that can affect our judgement when it comes to dealing with our finances. The important thing is to be aware of them and to be able to spot them when they occur.
Three simple rules can help you manage your finances more objectively:

A pictogram consisting of an orange circle (upper left), a yellow diamond (upper right), a yellow triangle (lower left) and a pink square (lower right).

1. Diversify your investments across several locations, sectors, asset classes, etc. and adopt a long-term asset management strategy, i.e. over several years or even decades, as opposed to the constant search for "good deals".

A pictogram showing orange binoculars with a pink and a yellow lens

2. Learn about basics of finance. Already, mastering the difference between stocks and bonds, as well as knowing that there are investments in individual companies but also "turnkey" solutions through active funds or ETFs, helps us to judge the true level of risk and performance potential of our investments.

A pictogram of a bar graph with three bars of different size and color (pink, orange, yellow)

3. Invest regularly. As we have seen, markets are often volatile - especially in the short term. It is better to invest, for example, a modest sum each month in a few (diversified! - see rule #1) investments than to accumulate a larger sum to be invested at a single time. This technique, which is often easy to set up through the programmed payments offered by most distributors , allows you to smooth out your entry prices and take a valuable step back in times of turbulent markets.