Behavioural Finance: How do feelings and perception influence our investment behaviour?

Financial decisions are often seen as a pure calculation of opportunities and risks. However, research in behavioural finance shows that feelings and perceptions strongly influence our investment behaviour - often without us being aware of it. Behavioural finance is a field of research that deals with the application of behavioural science findings to financial decisions and markets. It analyses how psychological factors influence our financial decisions. In the following interview with financial expert Prof. Dr. Tea Riedel, we take a look at how these factors shape investment behaviour and the typical errors in thinking that often occur.

Prof. Dr. Riedel, you are an expert in the field of finance. Can you briefly explain to us what exactly behavioural finance is and how it differs from traditional capital market theories?

Sure. Behavioural finance is an area of research that deals with how psychological and emotional factors influence the investment behaviour of individuals and the resulting market outcomes. While traditional capital market theories assume that investors act rationally in the sense of ‘homo economicus’ and make decisions based on expectations and preferences, behavioural finance explicitly rejects this assumption and assumes that our decisions are often influenced by emotional and cognitive biases. 

In addition, classic theories assume ‘market efficiency’, in which all information on the capital market is fully and quickly reflected in prices. According to this theory, future price movements are therefore unpredictable and no clear trends should be observable. Nevertheless, reality often shows overvalued markets and speculative bubbles that cannot be explained by classical theories. Instead, these phenomena can be explained by psychological behavioural patterns such as herd behaviour, excessive optimism and cognitive distortions.

What fundamental biases do investors often have?

Biases can be divided into cognitive and emotional biases. Cognitive biases usually arise due to errors in information processing or incorrect assumptions. A good example is confirmation bias. Individuals often tend to only consider information that supports their existing opinions and frequently ignore warning signals. Emotional bias, on the other hand, is caused by feelings such as fear or greed and individual beliefs. A well-known emotional bias is loss aversion. This describes the tendency to prioritise losses over gains. According to studies, we feel the pain of a loss about twice as strongly as the joy of an equal gain - an effect that can strongly influence our behaviour.

How does this loss aversion actually affect investment behaviour?

Loss aversion can lead to investors holding positions that are too risky or missing out on valuable opportunities. For example, investors often hold on to loss-making investments in the hope that the price will still recover. At the same time, they sell profitable positions too quickly for fear that these profits could soon be lost - this is known as the disposition effect. In the long term, this often leads to lower returns, as investors do not diversify optimally and focus too heavily on certain individual securities instead of aiming for a broader diversification as part of a long-term portfolio strategy. This shifts the focus from maximising long-term wealth to short-term gains and losses.

What differences do you observe between professional and private investors with regard to these behavioural patterns?

Professional investors are often more aware of their emotional biases and have strategies in place to avoid such biases. They also usually have a long-term investment horizon and a fixed strategy, whereas private investors often act more impulsively and are strongly influenced by short-term market trends or media reports. Professional investors focus on diversification and a clear investment strategy, while private investors tend to make speculative decisions or engage in stock-picking. The herd instinct is also more pronounced among private investors, as current trends are often imitated.

You mentioned the confirmation bias. What role does it play on the financial markets and how can investors counteract it?

Confirmation bias ensures that investors only perceive information that confirms their existing beliefs and ignore contradictory information. This often leads to them overlooking warning signals and holding risky positions because they believe they are right. An important step in avoiding this mistake is to actively engage with contrary opinions. Professional investors often use a so-called contrarian strategy for this: they consciously examine the arguments of the opposing side in order to scrutinise their position. A clear investment strategy can also help to avoid impulsive or confirmation-based decisions.

Another interesting point is the illusion of control. How does this bias influence investor behaviour?

The illusion of control and thus also the overestimation of one's own abilities (overconfidence) leads investors to believe that they can predict market developments. This can be seen, for example, in excessive trading - the frequent buying and selling of shares. Many investors trade too often and often take riskier positions because they overestimate their abilities. Frequent trading leads to high transaction costs and reduces returns in the long term. Particularly in unpredictable markets, you should realise that many developments are random and difficult to control. A passive strategy is often more successful here.

What strategies do you recommend to get a better grip on such emotional and cognitive distortions?

Firstly, awareness of these biases is essential. If investors recognise that they are prone to certain thinking errors, they can work on them in a targeted manner. A good investment strategy with clearly defined goals also helps to avoid impulsive behaviour. Long-term thinking is crucial to avoid being influenced by short-term market fluctuations. I also recommend broad diversification in order to minimise risk. Regular training in financial matters also improves the quality of decision-making and strengthens confidence in a sound investment strategy.

Finally, what would be your most important recommendation to private investors in order to develop healthy and successful investment behaviour?

The most important recommendation is to develop a clear and long-term investment strategy and not to be guided by emotions. Behavioural finance shows us that it is normal to make mistakes - the important thing is to become aware of these tendencies and work on them in a targeted manner. A long-term focus and sound financial knowledge are the best prerequisites for investing successfully and being aware of psychological pitfalls. Investing should be seen as a marathon and not a sprint. In this way, private investors can benefit in the long term and overcome psychological hurdles.

Many thanks, Prof. Dr. Riedel, for the valuable insights!