Behavioural finance studies the psychology of trading to explain anomalies in the stock market, such as surging and crashes in price.

Its basic tenet is that behaviours and biases affect trading behaviour. No matter how much research you do, or market information you have, your emotions can colour your decisions.

Behavioural vs traditional finance

This is in contrast to traditional finance, which is built on three core assumptions:

• Traders are rational

• Investors have a reasonable tolerance for risk

• Traders have complete and accurate information

One example of traditional finance is the efficient market hypothesis (EMH), which states investors are rational when trading and make their decisions using relevant market information. Based on this assumption, stocks always trade at their fair value and no amount of analysis can give a trader an edge over other traders.

However, behavioural finance challenges these assumptions and explores how individual traders and markets behave in practice, rather than theory. It places an emphasis on decisions often not being made rationally but as a result of unconscious psychological biases.

As Meir Statman, one of the founders of behaviour finance and author of Finance for Normal People, explains: “Standard finance people are modelled as ‘rational’, whereas behavioural finance people are modelled as ‘normal’.”

Trading biases

A key aspect of behavioural finance studies is the influence of biases, which can lead to irrational behaviours and decisions. We all make daily decisions based on our biases – whether it’s about what coffee to order, who to sit next to on the train, or which sandwich to get for lunch.

These same behavioural patterns also influence trading. While it’s almost impossible to make unbiased investment decisions, by understanding your investment bias, you may be able to moderate this instinctive behaviour and therefore improve your performance.

Behavioural biases in investing fall into two main categories: cognitive and emotional. Cognitive biases are based on established concepts that may or may not be accurate, while emotional biases are more spontaneous and based on your personal feelings.

Cognitive bias

As Eketarina Serikova, Currency.com’s trade behaviour analyst, explains, a cognitive bias stems from knowledge, not from an emotion or impulse.

“This type of bias means that the person is thinking about an issue rather than responding to it emotionally, but thinking about it does not mean they are immune from bias.”

Here are some of the most common cognitive biases:

• Confirmation

When researching a trade or investment, there is a natural tendency to pick up on information that confirms your prejudices. In social media this is called an echo chamber – we follow only people that reflect our opinions and beliefs.

• Gambler’s fallacy

This is the belief that if a particular event occurs more frequently than normal during the past it is less likely to happen in the future – or vice versa. In trading, this bias can cause traders to close profitable trades too early because they believe the stock is unlikely to continue its trajectory, as the chances of it becoming profitable become lower as time proceeds.

• Hot hand fallacy

This has its roots in basketball, with the belief that a player’s chances of hitting a basket are higher after a hit, rather than a miss. If he continues to score, he has a "hot hand".

In trading, hot hand bias occurs when a trader starts to believe they are on a winning streak, their hand is "hot" so they can’t lose. Similar to the gambler’s fallacy, the trader fails to recognise trades as independent.

• Negativity

People have a natural disposition to remember negative news or memories more than positive ones. This causes traders to place more weight on the negative outcomes of their trades, or on negative news stories which may influence their trades. As a result, they panic and make rash decisions, or they fail to act by waiting for the situation to get better.

• Herd bias

Also known as the bandwagon effect, herd behaviour is where people take a course of action simply because everybody else is doing it. In the world of investment this can take the form of panic buying or selling. More on this below

• Anchoring

This happens when a trader becomes fixated on pre-existing information or the first information they find when making decisions. Anchoring bias can cause traders to stay with losing trades in the hope of reaching the original or "their" price, illogically trading against the direction of the market or being unable to identify trading opportunities.

Emotional bias

“Emotional biases are biases based on intuition, feelings and emotions rather than knowledge or facts,” says Serikova. “They are emotionally driven and that’s not a good mixture for the ever-logical markets.”

Here are some of the most common emotional biases:

• Loss aversion

People often fear losses more than gains, which can prevent them from making logical decisions. In trading, loss aversion inhibits the trader’s ability to move on and seize new opportunities, or at least prevent further losses. Loss aversion also causes traders to deviate from their trading strategy. This can mean exiting trades early, being afraid of incurring losses, or not seizing a new trading opportunity.

• Overconfidence

This bias causes traders to take risky market positions because of their belief that they cannot fail. Overconfident traders are likely to open too many trading positions, take positions that are too large, and fail to analyse all necessary risks – all of which makes for an unsuccessful trading outcome.

• Disposition

Trading trends often show that investments performing well will continue to perform well, while investments performing badly will continue to perform badly.

However, the disposition effect makes an investor believe the opposite, so they could end up selling their best and hanging on to their worst.

• Familiarity

We all like something that is familiar, right? It’s why we go to the same coffee shop every morning for our "regular".

In trading, this means you are more likely to invest in sectors you know well, or feel loyal to. In doing so, you might miss out on opportunities in less familiar but more volatile stocks.

• Self-attribution

We’ve all met this type of trader, who believes their success is all down to their own actions. However, when things go wrong, they fail to recognise a potential lack of judgement.

This bias prevents traders from learning from their mistakes.

Trading anomalies

Behavioural finance is particularly useful when looking at market anomalies like bubbles and recessions. For example, there is evidence that stocks have greater returns on the last few days and the first few days of the month, while many stocks outperform during January.

There is no rational explanation for this, other than the influence of human behaviour – known as herding bias.

“When the majority of traders panic, the market rushes down at an accelerating pace,” explains Serikova. “This rapid fall draws in more and more participants and, as a rule, most people become part of the crowd.”

Understanding these trends and the trading behaviour that causes them can be used to help analyse market price levels and fluctuations when deciding what to invest in and when.

FURTHER READING: Trading biases to avoid as a novice trader

FURTHER READING: Trading psychology: getting in the mindset of a successful trader