Selecting an investment proposal is always a more or less rational process. One of the major concepts studied in this course is that the behaviour of investors is driven by psychological factors that may cause them to make irrational decisions in the financial markets. This is where behavioural finance comes in. A field that merges the principles of finance, coupled with knowledge drawn from psychology, to explain why people invest in a particular way.
Therefore, using psychology in investment helps investors and portfolio managers develop employee bias and enhance investment results.
In this article, we will discuss how behavioural finance influences modern portfolio management and why it's crucial for CFOs and financial directors to be aware of it.
What is Behavioural Finance?
Behavioural finance examines how and why people make financial decisions and how these decisions influence the markets. Classical finance assumes that investors are rational and do their best in terms of yield. Nevertheless, behavioural finance disputes this assertion, arguing that emotions, prejudice, and heuristics influence people's behaviour.
Key biases explored in behavioural finance include:
- Loss Aversion: The likelihood of fearing losses more than anticipating equivalent gains
- Overconfidence Bias: Investors believe they have better information or skills than they do
- Herding: Following the crowd despite individual market analysis suggesting otherwise
- Anchoring: Relying too heavily on initial information (e.g., the purchase price of a stock) when making decisions
These insights are crucial for CFOs and financial managers who oversee portfolio management processes and need to anticipate irrational market behaviour.
The Influence of Behavioural Finance on Portfolio Management
Modern portfolio management increasingly incorporates behavioural finance strategies to align investment decisions with the realities of human psychology. Here are a few ways behavioural insights affect portfolio management:
1. Managing Emotional Reactions in Market Volatility
During market downturns or volatility, emotions like fear and panic can dominate. Behavioural finance encourages building strategies that counteract impulsive behaviour, such as creating pre-set rules for buying and selling assets or employing dollar-cost averaging to mitigate the impact of market fluctuations.
2. Customising Portfolios Based on Investor Personality and Biases
Behavioural finance also promotes the customisation of portfolios based on individual biases. For instance, loss-averse investors may prefer portfolios favouring capital preservation over high returns, while overconfident investors may benefit from strategies limiting excessive trading.
3. Promoting Long-Term Thinking Over Short-Term Biases
Investors often succumb to short-term biases, focusing on immediate gains or losses instead of long-term goals. Behavioural finance strategies promote long-term thinking through goal-based investing, helping investors focus on their financial objectives even when market conditions fluctuate.
4. Incorporating Behavioural Finance in Risk Management
Understanding investor biases also leads to better risk management strategies. Portfolio managers can design diversified portfolios to reduce exposure to specific risks that investors might overestimate due to psychological biases (like recency bias, where recent events are given more weight than long-term trends).
Exploring Behavioural Finance Examples
Let us look at some real-world examples to understand behavioural finance in action.
Example 1: The 2008 Financial Crisis
Herd behaviour and overconfidence were the major behavioural finance processes during the 2008 financial crisis. The irrational exuberance in the stock market influenced investors' financial reasoning, encouraging them to invest in high-risk mortgage-backed securities.
Example 2: Post-Pandemic Market Recovery
Due to COVID-19, fear and uncertainty forced many investors to exit markets at the wrong time. However, those who implemented behavioural finance principles, for instance, avoided making decisions based on self-biases and made the most of conditions in the aftermath of the pandemic, bolstering the market, thus proving how a well-planned investment strategy worked for a better future.
The Future of Behavioural Finance for CFOs
With the growing focus on complex and dynamic portfolio management techniques, CFOs cannot overemphasize the role of psychology in investment decisions. With regard to behavioural finance, CFOs have the potential to develop robust financial strategies, enhance portfolio efficiency, and better navigate firms during volatile market periods.
Aspiring CFOs can also enrol in a full program, such as the Postgraduate Certificate Programme for Emerging CFOs from IIM Indore, powered by Imarticus Learning. This IIM CFO course provides knowledge on finance, strategy, and behaviour, allowing future business leaders to best prepare themselves for any business situation.
Conclusion: A New Paradigm in Portfolio Management
The inclusion of behavioural finance into the management of an investment portfolio is revolutionising investment portfolios. When biases and feelings interfere with financial decisions, investors and managers can realise the influence and implement more effective approaches, which contributes to favourable results. Whether dealing with risks or returns, behavioural finance makes portfolios ready for those uncertainties in the market.
CFOs and other senior financial decision-makers who already appreciate the role of psychology in investment decisions will position their organisations at the forefront of more resilient financial management over time, thus engineering more sustainable organisational growth forward.
