25th April 2018

Behavioural Finance

The subject of Behavioural Finance has become more widely discussed and researched over the last decade and is one that a lot of people find confusing. It takes into consideration the effects of psychological, social, cognitive and emotional factors on the financial decisions made by individuals and what the impact of this behaviour can have in different situations. In short, how people behave with money and finance in general and the possible reasons for their behaviour.

It is too big a subject to cover in this short article so I plan to look at just elements to explain in a more simplified manner what drives some financial decisions.

Familiarity Bias:

There is comfort in having your money invested in a business that is visible to you, even though there may be much greater benefits and gains to be made in diversification. Or putting it another way, if you are given two investment opportunities, one that you recognise and the other that you don’t, familiarity bias would suggest that we succumb to the investment we recognise. We like and trust things that are familiar to us and shy away from the unknown.

There can be down sides to this:

The familiar can easily be confused with the safe. Making an investment in a company known to you does not mean this is a better investment than a company you have never heard of.

Home Bias is another example, where people tend to invest in companies close to their homes or in the same country rather than researching a wider range of geographies.

Hyperbolic Discounting:

This is a tendency which sees people forfeit larger profits long term for smaller ones that are due to be arriving sooner. The pension is a good example of this. Many people will put off paying into a pension in order to delay the loss of monthly income they will incur, rather than taking time to consider the huge financial gains that could be made in the long run, if this contribution was started early.

If an event is too far in the future, the human mind is very good at dismissing it as not important and preferring to live in the now.

Loss Aversion:

Studies suggest that losses are twice as powerful as gains where human psychology is concerned. People feel much more averse to losing money than receiving it. This is a very important principle in economics and cognitive psychology. In a marketing setting, a price rise of a product creates a much larger reaction than the same product being discounted. Retailers also take advantage of this by offering the customer trial offers to encourage the consumer to take advantage of a price before they will make a loss by paying more for it.

There are numerous other factors that try and explain the driving force behind our financial decisions. The main point to take away is that when it comes to investments, trusting your gut may not always pay off and it certainly helps to think outside the box and be open to other suggestions or carry out independent research.

Rob Tinsley, Director, Pandora Retirement Consulting

www.pandoraretirementconsulting.co.uk

Retirement, Rob Tinsley, Pandora Retirement