3 tips that will allow you to get the utmost of behavioural finance

Hiding behind the intimidating term “behavioural finance” is a set of habits that frequently impact significant financial events. While separately they could be mistaken for individual quirks, grouped together they explain losses of a large part of retail investors. 

1. Traders are human

The majority of traders, with the exception of high-performance computers, are human – with all of their inherent flaws and quirks. In the 20th century we believed in the “efficient market hypothesis”: the market has already incorporated all available information and thus it’s able to self-regulate in times of mispricing. 

In practice, if it were to be true, it would be impossible for any investor to get consistent returns. This difference between rational expectations and reality is explained by behavioural finance. Learning its basics will help you score significant gains. 

Let’s look at some of the most popular biases influencing people’s behaviour in the financial markets. Have you spotted these biases in your own trades?

Settings anchors

Anchoring is a mental pattern (heuristic) that explains our inclination to use fixed reference points (or anchors) for making subsequent decisions. It is a trick used by retailers: an initial price of the product serves as a reference point for your appreciation towards the new price. The same trick may apply to seemingly “cheap” stocks. A smart question to ask yourself would be: is this instrument really cheap, or was it just overvalued before?

Supporting existing attitudes

Confirmation bias is a heuristic that urges you to select information that confirms your pre-existing beliefs. In practice, if you believe a certain thing to be true, you are more likely to notice information that supports your opinion rather than pay attention to views that reflect the opposite. Confirmation bias is the root cause for investor overconfidence. It leads them to ignore evidence of their strategy being a money loser.

Jumping on the bandwagon

Herd mentality bias explains your desire to give into claims whose only value lies in their popularity. A recent example is the bitcoin craze. While it is difficult to find rational explanations for the price movements, herd mentality explains most of the fluctuations, boom and bust cycles.

Unwilling to face the loss

It will always feel more painful to lose 100 dollars than to earn 100 dollars – that’s the essence of the loss aversion bias. In finance, loss aversion bias manifests itself as the inability to let go of bad decisions. Let’s say a stock has been losing money for a while, but you refuse to admit the losses and sell. Instead, you might be waiting for a miracle to happen.

2. Take advantage of nudges

You have the power to control your behavioural biases by keeping a hold of your nudges. In behavioural theory, nudges are aspects that alter people’s behaviour in a predictable way without forbidding any options or significantly changing their economic incentives.

In the world of finance, one of the popular nudges is a trading journal. Laying all facts on paper can be a helpful habit to help you overcome your irrational biases. Be strict about your bottom and upper line. If you define the maximum you’re willing to lose on any investment, it’s easier to hold yourself to account if things go sour. The same applies to gains. If you are clear about your reason for purchasing an instrument – be it long-term horizon prospects or a quick flip – you will be less prone to act on impulse.

One of the best ways to take control of your behaviour is to avoid checking your portfolio too frequently. Leaving high-frequency traders aside, investors who refrain from peeking into their portfolios every day will always keep level-headed. 

3. Rebalance your portfolio

Act on the lessons learned by rebalancing your portfolio. How do you do that?

Before composing a portfolio, you have decided that you will put 70% of your funds in stocks and 30% in crypto currencies. You start off with $1,000, putting $700 in stocks and $300 in crypto. Surprisingly, your crypto portfolio increases to $600 so now the value of your portfolio is $1,300. With your initial strategy in mind, now is a good time to divest $210 in stocks and maintain the 7:3 split. 

Rebalancing your portfolio allows you to build consistency and keep your emotions in check.

The world is out there to get you. Make sure you’re not taken away with the tide. Researchers have identified the patterns that may set you back. Now it’s up to you to address them in your life.