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We don’t always make rational decisions about money and investing. That’s why we have a whole field of study to explain our sometimes strange behaviour. Where do you, as an investor, fit in? Understanding behavioural finance may help you answer this question.
Standard economic theory expects traders to act rationally. They should make decisions based on complete information to maximise utility. But as traders, do we? Researchers have questioned this assumption, revealing that human behaviour often deviates from rationality. Behavioural finance attempts to understand how emotions impact financial decisions.
The “Quantitative Analysis of Investor Behavior” report by Competitor IQ reveals exciting insights. Competitor IQ, formerly Dalbar, is a financial services research firm. Its reports highlight that average investors consistently underperform the market. In 2015, the ordinary equity mutual fund investor performed 8.19% worse than the S&P 500. This trend continued in 2020, with typical equity investors earning 5.35% less than the S&P 500 return in 2019.
Investor behaviour towards decision-making processes in financial markets is complex. However, we identify factors that influence the process. We group these factors into economic, psychological, sociocultural, technology-related, and regulatory categories.
In This Guide
1. Economic Factors
Economic factors are fundamental in influencing investor behaviour. Key elements include:
Interest Rates
Inflation
Economic Growth
Unemployment Rates
Exchange Rates
Central banks’ monetary policies directly affect interest rates. These, in turn, influence the cost of borrowing and the return on savings. Low interest rates generally make borrowing cheaper, encouraging investment in higher-risk assets. In contrast, high interest rates can have the opposite effect.
Inflation erodes money’s purchasing power, impacting the consumer behaviour and investment strategies. Investors typically seek to hedge against inflation. So, during inflation, the demand for commodities, cryptocurrencies, and inflation-linked bonds shoots up.
Gross Domestic Product (GDP) growth rates are a primary indicator of economic health. High growth rates boost investor confidence. So, they increase their investment in growth-oriented assets.
High unemployment reduces consumer spending and, hence, low corporate profits. This situation can cause economic distress and affect stock prices and investor confidence.
Exchange rate fluctuations can significantly impact returns for investors involved in international markets. A stronger domestic currency can reduce the value of foreign investments. This is while a weaker currency can enhance it.
2. Psychological Factors
Psychological factors also influence investor behaviour. Studies like those by Dalbar reveal that average investors consistently underperform the market. This is due to psychological pitfalls like fear of regret and mental accounting. Investors sometimes avoid selling stocks. The goal is to prevent the regret of realising a loss, even when it’s clear that holding on is unwise.
Additionally, some tend to allocate money into different mental categories. As a result, it can can irrationally affect financial decisions. For example, losing a $20 bill may not deter someone from buying a theatre ticket, but losing it might. There’s also prospect theory and loss aversion. People are more stressed by potential losses than they are pleased by gains. Such action often leads to irrational investment decisions like holding onto losing stocks.
So psychological factors that influence investor behaviour include:
Risk Tolerance
Behavioural Biases
Emotional Reactions
Cognitive Dissonance
Individuals’ willingness to risk varies according to personality, financial goals, and life circumstances. Risk-averse investors go for safer assets. On the other hand, risk-tolerant investors seek riskier ones for higher returns.
We all have our biases as humans. Common biases include overconfidence, where investors overestimate their knowledge or predictive capabilities. There’s also herd behaviour. Individuals follow trends, often leading to market bubbles or crashes.
Fear and greed are potent motivators. During market upswings, greed can lead to speculative bubbles. Fear has the opposite effect. Panic selling during market downturns is mainly due to fear of losing money.
Investors may experience discomfort when new information conflicts with their beliefs. We could easily make irrational decisions to justify previous actions.
3. Sociocultural Factors
Social factors also play a significant role. Economic sociology highlights that people are more conservative when making investment decisions. Plus, it shows labels like “retirement “or “college savings” can affect risk tolerance. Sociocultural influence extends to how societal norms and media coverage can shape investment trends and behaviours.
Sociocultural factors shape investment behaviours as follows:
Attitudes Toward Risk
Peer Pressure and Social Influence
Demographics
Media and Information Dissemination
Different cultures have varying attitudes towards risk and uncertainty. So, how an individual approaches investing will depend on their attitude towards risk. For example, cultures that value stability and security may favour conservative investments.
Friends or family can influence your investment decision. Trends also play a significant role, as people want to feel included.
Age, education, and income levels play crucial roles. Younger investors may have a longer investment horizon and a higher risk tolerance. Older investors, on the other hand, prefer safer, income-generating investments.
We cannot understate the role of the media, particularly social media, in informing and shaping public perception. Positive or negative news coverage can influence market sentiment and investor actions.
4. Technological Factors
Technological advancements are also critical in influencing our investment behaviour. Tech influences our behaviour as follows:
Access to Information
Online Trading Platforms
Algorithmic Trading
Blockchain and Cryptocurrencies
The internet and financial technology have democratised access to information. Real-time analysis tools are now readily available.
Trading platforms have democratised trading, taking it to the masses. They charge lower transaction costs and allow broader participation in financial markets. Traditional brokers used to charge high fees. This prevented small investors from participating in the market.
Technology has brought better trading tools influencing market dynamics. Sophisticated algorithms can execute trades at high speeds and volumes. Investors don’t have to stop going about their routine duties. They can trade without interfering with their day-to-day business.
Emerging technologies like blockchain have introduced new asset classes. Such assets include cryptocurrencies and non-fungible tokens (NFTs). With increased asset classes, investors have alternative investment opportunities to diversify their portfolios.
5. Regulatory Factors
Trading and investment happen within the confines of the law. Regulations maintain the market integrity and protect investors. At the same time, regulations influence our investing behaviour as follows:
Securities Regulations
Tax Policies
Financial Professional Standards
Regulatory Bodies
Laws and regulations governing securities markets ensure transparency, reduce fraud, and protect investors. Compliance requirements can impact corporate behaviour and investor confidence.
Taxation on capital gains, dividends, and interest income affects investment decisions. Favourable tax treatments can encourage investment in certain asset classes. However, high taxes deter it.
The standards guide moral and professional choices and advance transparency. Regulatory requirements to abide by standards boost investor confidence. Such standards include GAAP (Generally Accepted Accounting Principles or International). There is also the IFRS (International Financial Reporting Standards).
Regulatory institutions contribute to market stability and investor protection. Such bodies in the US include:
- CFTC – Commodity Futures Trading Commission
- SEC – Securities and Exchange Commission
- FINRA – Financial Industry Regulatory Authority
In the UK, we have:
- FCA – The Financial Conduct Authority
- PRA – The Prudential Regulation Authority
- FSCS – Financial Services Compensation Fund
Conclusion
Investor behaviour is influenced by economic, psychological, sociocultural, technological, and regulatory factors. Behavioural finance helps understand the sometimes irrational nature of investment decisions. By recognising these elements, investors can make better decisions. They can also manage risks and optimise returns in a dynamic financial landscape. Note that a well-thought-out strategy and discipline can help avoid common investing mistakes driven by biases.