Behavioural biases and their impact on financial decision-making

Spotlight: Behavioural Economics

Behavioural economics suggests that psychological factors and biases play a key role in influencing the financial decisions of investors.

Behavioural biases are defined as irrational beliefs that influence the decision-making process in ways that we might not even realise. We can think of them as automatic processes that help speed up human decision-making by filtering information quickly without having to consciously weigh every possible outcome. These biases exist because as humans our brains are wired to look for patterns in the world around us. For investors, having such biases may lead to poor decision-making and adverse portfolio outcomes.

There are two different ways of thinking that work together when making decisions. The diagram below explains this. We then show some examples of typical biases that an investor might experience.
 
Source: Thinking, Fast and Slow - Daniel Kahneman

There are well over 100 different types of behavioural biases but below are three common ones experienced by investors:
 
Regret aversion (the fear of regret) – Investors may go to great lengths to avoid making choices that could lead to feelings of regret later on, even if it is a less sensible investment decision. An example of this bias could be an investor remaining invested in an asset class (equities for example) that is performing well, whilst ignoring signs of an impending market downturn.
 
Loss aversion – this is when the negative feelings from experiencing a loss, far outweigh any enjoyment felt from gains. In that sense, loss aversion is similar to fear. Negative emotions, such as those brought about by criticism, tend to have a greater impact than positive ones, such as praise. This phenomenon aligns with Charles Darwin’s quote that “everyone feels blame more acutely than praise".
 
Confirmation bias – this is when investors tend to hold onto information that aligns with their own existing beliefs and values. For example, if an investor heard that gold was a better investment than equities, the investor may specifically look for evidence of when gold outperformed equities, whilst at the same time ignore any periods where gold underperformed equities.   
 
The key to tackling these biases is:

1. Acknowledging their existence (after all we are all human!) and understanding how they influence decision making.
2. Avoiding impulse decisions can help avoid the pitfalls of behavioural biases – when emotions run high, biases are more likely to occur.
3. If you are unsure, seeking advice from investment professionals can be helpful as they can provide an impartial view which should reduce the chances of making poor investment decisions.

The Noise​

• US consumer confidence retreated in February following three straight monthly increases, as worries about the labour market and the domestic political environment increased. Though inflation remained the main preoccupation of US consumers, they are now less concerned about food and gas prices, and more concerned about their job security and the lead up to November’s presidential election. Supporting the reduced inflation concerns, the core personal consumer expenditures index increased 0.4% in February, up 2.8% year-on-year. This was the smallest annual increase in three years and will likely keep a mid-year interest rate cut on the table.

• Eurozone manufacturing activity continued to contract last month amid weak demand, the 20th successive month of an activity contraction. Firms however were optimistic about the year ahead, though have reduced headcount for a ninth month. Backlogs of orders were also reduced as factories tried to stay active. The downturn in Germany deepened in February as output and new orders declined at a faster rate. Italy and France on the other hand showed signs of improvement though still experienced a decline. Spain outperformed its European peers, where factory activity expanded for the first time in almost a year as domestic demand picked up.

• Gemini, Google’s version of ChatGPT has been taken offline for further testing after issues with its generated responses. Google started offering image generation through its Gemini AI models in February, but users on social media had flagged that the model returns historical images that were sometimes inaccurate. Though no AI model is perfect, Gemini has shown a tendency to produce bias responses. While attempting to address this issue, the tech giant seems to have inadvertently generated a new problem: the output now strives excessively to be politically correct, resulting in somewhat absurd responses. The model has even gone as far as refusing to provide responses to certain queries. AI models are trained on huge amounts of data publicly available on the internet, which contain all sorts of biases. Correcting for such biases is difficult and will continue to be an ethical issue for the AI community.

The Numbers

The Nuance

With the London Stock Exchange home to global companies such as Shell, HSBC, and AstraZeneca that dominate their respective industries, one might expect it to be a sought-after market for investment. However, from the period of strong returns spurred by Margaret Thatcher induced privatisations in the 1980s, the UK’s equity market has seen its fortunes deteriorate over the last decade. Once the largest stock exchange in the world, it is now only the seventh-biggest globally. The total capitalisation of London-listed equities has fallen from a high of £3.4 trillion in 2007 to £2.4 trillion in February 2024. Over that same period, the value of US stocks almost trebled to $53 trillion.

British companies are increasingly choosing other markets to list their shares. The high-profile move by Cambridge-based chip designer Arm Holdings to list in New York instead was a bitter blow to the UK’s hopes. Just £800 million was raised by companies on the London Stock Exchange in initial public offerings in 2023, the least since 2009. This fits the storyline of a country whose economic progress has been hindered by low productivity, under-investment and disruption to trade from Brexit.

Trading volume has slumped in recent years, with daily trading volumes down almost 75% from its peak. Investors tend to pay less for illiquid stocks as a hedge on the risk of a bigger loss when they come to sell. On a forward price-to-earnings basis, UK stocks are trading at a 46% discount to their US counterparts.

Looking at what’s to blame, one could point at UK government rules introduced in the early 2000s. They resulted in pension funds shifting away from equities, instead purchasing UK government bonds. From highs of 32% in 1992, UK pension funds only held 1.6% of UK-listed stocks in 2022. Though difficult to draw a direct link to Brexit, it has clearly forced banks to reallocate personnel to rival financial centres in Europe. Amsterdam has emerged as a more attractive European listing venue, with companies drawn by a more favourable regulatory environment.

All of this highlights the importance of implementing a globally diversified approach to portfolio construction.

Fortunately, the UK isn’t sitting on hands and hoping things get better on their own. The FCA set out plans late last year to simplify its listings regime in an effort to revive interest in London’s stock markets. It also stuck to plans to allow companies to carry out more activities without putting them to a shareholder vote. Chancellor of the Exchequer Jeremy Hunt has also been considering ideas such as a so-called British ISA, something we may hear about more in next week's Spring budget. Whether any of this will be able to turn the oil tanker that is the UK stock market’s decline remains to be seen.

All investment views are presented for information only and are not a personal recommendation to buy or sell. Past performance is not a reliable indicator of future returns, investing involves risk and the value of investments, and the income from them, may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.

Any views expressed are based on information received from a variety of sources which we believe to be reliable, but are not guaranteed as to accuracy or completeness by atomos. Any expressions of opinion are subject to change without notice.