Where have you heard about behavioural finance?

The behavioural finance definition refers to a relatively new field in economics that looks at the role of emotions when making investment decisions. The field challenges the traditional approach, where investors are seen as always being rational and stock prices reflect all known information about the companies.

Instead, behavioural finance argues that stock prices are affected by the emotions of market participants. A good example is what happens when an investment bank like Goldman Sachs (GS) reports a good quarter and raises its forward guidance. The stock prices of other banks rise too as investors anticipate better results from all the businesses within the sector.

Herd bias is one of the phenomena described in behavioural finance. It refers to a process where investors buy assets because of the mood of the market. A good example of this concept was during the dot com bubble, where people invested in bogus companies just because they had a dot com suffix. At the time, the fear of missing out (FOMO), made people invest in companies that had no revenue and profit.

Other important behavioural finance examples include mental accounting, anchoring and high self-rating.

If you are interested in finance, economics or trading, you have likely heard about behavioural finance directly or indirectly. 

First, you may have indirectly heard about it if you have covered a course on trading psychology. Also, the term might have crossed your path if you read Irrational Exuberance, a highly acclaimed book by Robert Shiller that discusses how bubbles in the stock market form and how the fear of missing out affects investors’ returns.

Additionally, you may have heard about it from your financial advisor or investment manager. They often use a famous phrase “past performance is not an indicator of future success” when citing behavioural finance, meaning to warn their clients about over-relying on the past performance of an asset they want to invest in.

What you need to know about behavioural finance

Having knowledge and expertise in fundamental and technical analysis is good for investors. Equally important is the knowledge of the principles explained in behavioural finance.

Concepts like herd following may help you identify when a bubble is forming. They may also allow you to identify investment opportunities when looking at undervalued and overlooked stocks. 

Microsoft (MSFT) is a good example of this. Before Satya Nadella became CEO, the company had a price-to-earnings ratio of below 15, because investors had minimal expectations of the business. At the beginning of 2020, Microsoft had a trailing-12-month PE of about 27.

In addition, behavioural finance helps to avoid making simple mistakes when investing, such as buying when you are not ready, or exiting an investment before your ideal target is reached.