Understanding behavioural finance

We often like to think of ourselves as rational beings who make decisions logically, especially when it comes to our finances. However, the reality is that our emotions, beliefs, and biases frequently influence our investment choices, sometimes leading us to act against our own best interests. This is where behavioural finance comes in.

Behavioural finance is the study of how psychology impacts our financial decision-making. By understanding the common mental pitfalls that investors face, we can learn to avoid them and make more informed choices. This field examines both individual behaviour and market behaviour, offering insights into how psychological phenomena can drive large-scale market movements.

Given the current market environment, influenced by factors such as tariffs and geopolitical tensions, it's not unusual to feel nervous. However, understanding our emotions and biases can help us avoid decisions that may have negative impacts in the future.

Key biases in behavioural finance

1. Confirmation bias: We tend to seek out information that confirms our beliefs and ignore anything that contradicts them. For example, an investor might only look for positive news about a company they like, ignoring any negative reports. This can lead to overconfidence and missed risks. In today's market, this bias might cause an investor to overlook the potential adverse effects of new tariffs on a company's profitability

2. Recency bias: Recent events can heavily influence our perception of the future. If an investor experienced losses during a market downturn, they might become overly cautious, even when the market has recovered. This can lead to missed investment opportunities. For instance, the recent volatility due to trade policy changes might make investors overly pessimistic

3. Loss aversion: We fear losses more than we value gains. This can cause investors to hold onto poor-performing investments, hoping to recover their initial investment, instead of reallocating to better opportunities. In the current environment, this might mean holding onto stocks affected by tariffs, hoping for a rebound

4. Familiarity bias: We prefer investments we know, like domestic companies or well-known brands. While this feels safer, it can lead to a lack of diversification and increased risk. With the shifting global trade landscape, relying solely on familiar domestic investments might expose investors to higher risks.

5. Mental accounting: We categorise money into different groups and treat it differently. For example, someone might splurge on a luxury item with a tax refund, even if it doesn't fit their overall financial plan. This can lead to poor financial decisions, especially when market conditions are uncertain.

6. Framing: We often evaluate investments in isolation rather than as part of our overall portfolio. By considering the entire portfolio, we can better manage short-term losses and stay committed to long-term goals. In the current market, framing investments within the broader context of global economic shifts can provide a more balanced perspective

Overcoming financial irrationality

These biases are natural, but overreliance on them can be harmful. It's important to recognise when our psychological alarm bells are helpful and when they might be working against us. When we see volatility in markets, it's good to remind ourselves that pullbacks in markets are normal and can present opportunities for active managers, like Schroders Personal Wealth, to capitalise on them to deliver results for our clients.

Here are some investment tips to help you remain on track:

1. Avoid making rash decision: Acting in the moment could lock in any losses and impact any potential future gains. It's crucial to take a step back and assess the situation calmly. Rash decisions, driven by fear or panic, can lead to selling investments at a loss, which might have otherwise recovered over time.

2. Set your sights on the long term: Market falls can signal potential opportunities, as prices dip. Markets can - and have - recovered over time (although there are no guarantees). By focusing on long-term goals, you could avoid the pitfalls of short-term market fluctuations.

3. Stop looking at your account: We fear losses more than we like gains. You'll thank yourself later by not checking in constantly on the value of your investments. Frequent monitoring can lead to emotional reactions and impulsive decisions. Instead, set regular intervals to review your portfolio, allowing you to stay informed without becoming overly reactive.

4. Speak to an adviser: Consulting with a financial adviser could help you navigate the complexities of the market and avoid common mistakes. An adviser is able to provide a balanced perspective, helping you stay focused on your long-term strategy and making adjustments as needed based on professional insights.

Taking the next step

Understanding behavioural finance and recognising our biases is a crucial step towards making better financial decisions. However, navigating the complexities of the market can still be daunting, especially in today's unpredictable environment. If you find yourself feeling uncertain or nervous about your investment choices, speaking to an expert can make a significant difference.

At Schroders Personal Wealth, our advisers are here to help you avoid common mistakes and stay focused on your long-term goals.