In all of the previous slides we’ve assumed that all investors are rational, ie they will act in a way to maximise their happiness. However, this is not always the case as some investors will include psychological factors to influence their decisions, leading them to make an irrational decision.

Behavioural finance is an area of research that explores how emotional and psychological factors affect investment decisions.

It attempts to explain market anomalies and other market activity that is not explained by the traditional finance models such as modern portfolio theory and the EMH, and offers alternative explanations of the key question of why security prices deviate from their fundamental values.

Psychological factors

Prospect Theory/Loss Aversion

• People place different weights on gains and losses.
• Someone will put more emotion into a loss than a profit of the same amount.
• Research has also found that people play safe once they’ve made a gain, but when facing a loss they are happy to increase their risk to increase a potential gain.
• This may include a reluctance to realise a loss, so people hold onto a poor performing investment for longer than they should in the hope that over time it will improve.

Regret

• People tend to feel sad and grief having made an error of judgement, resulting in a loss making investment.
• It is this fear that stops an investor acting rationally to sell the investment, instead they are irrational and hold it to hope it may produce a profit.
• The same can be said once an investor has made a small profit. They act irrationally and sell the position for a small profit due to the fear of regret in case it turns into a loss.

Overconfidence

• People overestimate their skills and ability and underestimate the likelihood of a bad outcome.
• When the markets are rising, investors become optimistic and pessimistic when markets fall.
• They give too much weighting to recent experience and trends that usually try contrary to statistical odds or long run averages.