What is behavioural finance, and what does it mean for FinTech?
Wednesday, September 21st, 2022
Psychology hugely impacts decision-making, and the world of financial investment is no different. Even the best investors sometimes make irrational choices, act against their own good judgement and make decisions based on personal bias – a phenomenon which can be explained through behavioural finance.
Reddit’s GameStop frenzy is one example of how emotions and biases influenced the market in 2021, when a group of stock traders persuaded thousands of others to buy stocks in a company, in revolt against short-selling hedge funds. In that period, the stock went from a low of $2.57 per share to a peak of $483, before plummeting back down and costing investors millions.
By studying behavioural finance, we can better understand and predict financial decisions that may otherwise look random and unreasoned. On the FinTech Management MSc at Ulster, you’ll study behavioural finance alongside leadership and management modules to build a well-rounded knowledge of financial markets and make better, more informed business decisions.
Read on for more examples of behavioural finance and why it is a key focus area for future FinTech leaders.
What is behavioural finance?
Behavioural finance is a specialism that looks at the psychology behind financial decision-making in an effort to explain market anomalies and predict irrational investment behaviour.
Similar to behavioural economics, behavioural finance questions traditional theories in mainstream finance to argue the importance of human psychology in predicting and analysing non-rational investment decisions and understanding market inefficiency.
The field emerged through the work of psychologists Daniel Kahneman and Amos Tversky, and economist Robert J. Shiller, in the late 1970s and early 1980s.
How does behavioural finance relate to FinTech?
Contradicting the long-held efficient market hypothesis (EMH), behavioural finance takes the view that markets are not fully efficient and are affected by the pervasive, deep-rooted and subconscious biases of investors.
The field goes some way to explaining market anomalies such as bubbles and deep recessions and helps analyse market price levels for speculation and decision-making purposes.
Furthermore, the growing prominence of AI and machine learning in the FinTech sector gives behavioural finance new significance. Alongside developments in data analytics, technology can make better sense of, track and predict human behaviour and input these insights into AI technologies.
An example of the applications of behavioural AI include online bank Revolut’s budget planner, which uses insights on customer behaviour to develop smart analytics which can predict monthly spending and advise users accordingly.
In better understanding human actions, FinTech organisations have a better chance of adding value and retaining customers.
“There is incredible opportunity for leveraging technology to deliver the understanding, reassurance, and peace of mind that investors truly value, through every stage of the advisor-client journey.” – Erik Clarke, founder and CEO at Orion on behavioural finance in consulting.
Behavioural finance concepts
The Behavioural Finance module on Ulster’s Masters in FinTech Management covers the foundations of behavioural finance, looking at opportunities for behavioural investing through the evaluation of algorithmic trading strategies.
On this module you’ll learn a range of psychological terms to define investor sentiment, including these five key concepts:
Mental accounting – the idea that people allocate money for specific needs and purposes.
Herd mentality – this term refers to the tendency for people’s behaviour and beliefs to conform to a wider group. In the world of investment, ‘herd’ investors will buy or sell shares in a particular company or sector because others are doing the same. This social conformity can be predicted among the population and is often determined by a lack of confidence in individual judgements.
Emotional decision-making – this term encompasses seemingly non-rational decisions that are made based on emotions or emotional strains such as fear, anxiety, anger or uncertainty.
Anchoring – investors that anchor their investments tend to rationalise their spending based on their own references and spending levels, as based on a budget and/or other utilities.
Self-attribution – overconfidence in one’s own skills or knowledge trips up skilled investors every day. Professionals with intrinsic skills in a particular area may overestimate their knowledge and make errors of judgement.
Key behavioural finance terms
Alongside the concepts above, the Association of Chartered Certified Accountants (ACCA) explains a number of other terms often used when discussing behavioural finance:
Market paradox – the paradox of the market occurs because investors must believe that markets are inefficient in order for them to be efficient. By trading shares, investors are banking on some element of inefficiency (a slow reaction to new information, for example) in order to profit from said changes and create an efficient process.
Loss aversion – unlike noise traders, loss-averse investors tend to err on the side of caution when making decisions. Loss aversion shows a lack of confidence in one’s judgements, even when value analysis suggests the investment is set to make significant gains in the long term. As a result, investors with loss aversion tend to invest in companies showing stable but low profits, over and above companies with high but volatile growth.
Momentum effect – similar to herd mentality, the momentum effect describes how periods of rising share prices often see increased investor optimism and willingness to invest. The opposite can also be said for price drops causing pessimism among investors. As a result of the momentum effect, periods of ‘boom’ and ‘bust’ may last longer.
Bias – different types of bias can affect many of our decisions. Familiarity bias is the tendency for investors to invest in what they know, whilst confirmation bias refers to the tendency for investors to accept information that confirms an already-held belief.
Study behavioural finance online at Ulster
Ulster University’s online FinTech Management Masters programme covers a broad range of FinTech specialisms alongside modules on business analysis and data science to develop well-rounded graduates ready for senior positions in the FinTech sector.
The programme is offered 100% online for busy professionals anywhere in the world, with 24/7 access to course materials and discussion boards, where you can interact with your lecturers and professional peers. Read our blog post for more reasons to study FinTech Management.