Behavioural finance encompasses research that is not based on the traditional assumptions of expected utility maximization by rational investors in efficient markets. Instead, it relies on two strong arguments: that the ways people think tend to differ from one another (cognitive psychology); and that there are limits to arbitrage (i.e. when markets are inefficient). Empirical support has been found for these two aspects making up behavioural finance in explaining investor behaviour. Due to cognitive psychology which endeavours to explain investor behaviours, some patterns of cognitive bias have been identified in related research. These include the biases of overconfidence, heuristics, mental accounting, disposition effect and conservatism which have been associated with gender, age, entrepreneurship, culture, excessive extrapolation, loyalty and familiarity.
The psychology literature is rich in references documenting that most people are overconfident most of the time – that is, they believe they are more skilful or knowledgeable than they really are. For example, many people think highly of their ability to make wise choices in investment. These people believe that they can time the market and pick the next hot shares that will yield the highest returns, though in most instances, most shares tend to do well when the market is rising. On the other hand, when their shares drop in price, they will generally blame it on circumstances over which they had no control, such as the general condition of the market and the economy. Such self-perceived competence has been found to play a role in investors’ willingness to act on their own judgement. For instance, Graham et al., have documented that perceived competence leads to overconfident investors who tend to trade too often.
Many investors use rules of thumb because these rules make decision-making easier, especially in cases of equity investment where investors face too many pieces of information. Therefore, when it is difficult to make investment decisions, they tend to follow three major heuristics including ‘availability’, ‘representativeness’ and the ‘1/N rule’. For example, investors find it is easier to invest in shares that are easily available to them (e.g. local and familiar shares). Although knowing that the benefit from risk diversification can be better achieved by managing portfolios of local and international assets, many individual investors may find it costly and time-consuming to learn about unknown international shares or less familiar local shares.
Too often, individual investors’ decisions may be fuelled by recommendations from peers and family. In seeking investment advice and information, 36% of direct investors surveyed by the ASX in 2008 reported that they sought advice from trusted family and friends. Similarly, individuals may find it easier to learn about opening a mutual fund account by talking to their friends than through using other mechanisms. Even without verbal recommendations or advice, people watch the behaviours of others and learn through interacting with them, hence behaving accordingly.