Learn how emotions and biases can shape investment decisions, and what may help you stay focused on your long-term goals.

Investing may appear to be driven by numbers, research and financial forecasts. In practice, every investment decision is made by a person, and people do not always respond to information in a purely rational way.

Markets rise and fall. Headlines create excitement or concern. When money and long-term goals are involved, emotions such as fear, optimism and regret can become powerful influences.

Behavioural finance explores this human side of investing. By understanding how emotions and mental shortcuts can affect your judgement, you may be better placed to make considered decisions and remain focused on the purpose of your investment plan.

Key takeaways

• Behavioural finance examines how psychology can influence financial decisions.
• Common investment biases include loss aversion, recency bias, herd behaviour, overconfidence, confirmation bias and anchoring.
• Both excessive risk-taking and avoiding investment altogether can be emotional responses.
• A clear plan, appropriate diversification and scheduled reviews can help reduce the influence of short-term emotion, although they cannot remove investment risk.
• Financial advice can provide structure and an objective perspective when markets or personal circumstances change.

What is behavioural finance?

Behavioural finance is the study of how psychological influences, emotions and cognitive biases affect financial decisions. It helps explain why investors may make choices that do not always support their stated goals, even when relevant information is available.

Traditional financial theory often assumes that people assess information logically and choose the option that best serves their interests. Behavioural finance recognises that real decisions are also shaped by past experiences, personal beliefs, social influence and the way information is presented.

These influences are not signs of poor judgement. They are normal features of human decision-making. However, they can become a problem when they cause someone to abandon a suitable long-term strategy, take more risk than they can afford or avoid reasonable opportunities without considering the full picture.

Understanding investment psychology does not remove emotion from investing. Instead, it can help you recognise when emotion may be directing a decision that deserves more careful thought.

Why emotions influence investment decisions

Investors can experience an emotional cycle as markets move.

When values rise, confidence may grow. Positive headlines and stories of other people’s gains can create a fear of missing out, sometimes encouraging investors to put in more money, concentrate their holdings or buy something they do not fully understand.

When markets fall, the same confidence can quickly turn into anxiety. Seeing the value of a portfolio decline may create an urge to sell immediately, even when the original investment objective and timeframe have not changed.

Recent FCA research shows how quickly emotion and social influence can affect decisions. In a survey of 2,000 UK investors aged 18 to 40, 66% said they made investment decisions in less than 24 hours. More than half, 51%, said fear of missing out had led them to invest more than they originally intended. The findings relate specifically to the surveyed age group, but they illustrate how hype can shorten the decision-making process. Read the FCA research.

Reacting to short-term movements can lead an investor to buy after prices have already risen or sell after they have fallen. Selling may sometimes be appropriate, but the decision should be based on whether the investment or your circumstances have materially changed, rather than on market movement alone.

Six common investment biases

Cognitive biases are mental shortcuts that help people process information quickly. They are useful in everyday life, but they can distort investment decision-making. Several biases often appear when markets are rising, falling or attracting intense attention.

Loss aversion

Loss aversion is the tendency to feel the pain of a loss more strongly than the satisfaction of an equivalent gain.

It can prompt an investor to sell during a downturn simply to stop the discomfort of seeing values fall. It can also have the opposite effect: someone may hold on to an unsuitable investment because selling would make the loss feel final.

The important question is not whether an investment is above or below the price you paid. It is whether continuing to hold it remains appropriate for your goals, timeframe and wider portfolio.

Recency bias

Recency bias occurs when someone gives too much weight to recent events and assumes the same pattern will continue.

After a period of strong performance, an investor may expect further gains and take more risk. Following a downturn, they may assume losses will continue and move away from investments at a time when prices have already fallen.

Markets do not move in a straight line, and recent performance cannot reliably predict what will happen next. A longer-term view can help place the latest rise or fall in context.

Herd behaviour and FOMO

Herd behaviour describes the tendency to follow what other people are doing. In investing, it can be reinforced by financial news, social media, friends or stories about rapidly rising assets.

Popularity can create a sense of safety or urgency, but it does not show that an investment is suitable. By the time an opportunity becomes widely discussed, much of its rise may already have happened. The risks may also receive less attention than the potential rewards.

Before following a trend, it can help to ask what role the investment would serve in your plan, what could cause it to lose value and whether you could afford that loss.

Overconfidence

Strong performance can lead investors to place too much confidence in their ability to choose investments or predict market movements.

Overconfidence may result in frequent trading, a portfolio concentrated in a small number of investments or more risk than originally intended. It can also make someone less willing to question an earlier decision when new information emerges.

A written investment strategy provides a useful reference point. It allows you to compare a proposed change with your agreed objectives rather than relying on how confident you feel at that moment.

Confirmation bias

Confirmation bias is the tendency to favour information that supports an existing belief and dismiss evidence that challenges it.

For example, an investor who feels strongly about a company may focus on positive forecasts while overlooking changes to its finances, market or competitive position. Online recommendations and personalised feeds can strengthen this effect by repeatedly presenting similar opinions.

Actively considering the case against an investment can produce a more balanced assessment. Asking what would prove your original view wrong can be particularly useful.

Anchoring and familiarity bias

Anchoring happens when a decision becomes tied to one reference point, such as the price originally paid for an investment or its previous highest value. That figure may feel important even when it says little about the investment’s future prospects.

Familiarity bias can lead investors to favour companies, sectors or markets they recognise. Familiar investments may feel safer, but a narrow focus can leave a portfolio more exposed to one area of the market.

Appropriate diversification can help reduce that concentration risk. However, diversification does not guarantee a profit or protect against every loss.

When cash becomes a comfort zone

Investment psychology does not only influence people who take too much risk. It can also affect those who avoid investing altogether.

Cash plays an essential role in a financial plan. It can provide an emergency reserve and meet spending needs that arise in the short term. Its stability may also feel reassuring compared with investments whose values fluctuate.

However, holding more cash than you need for long-term goals can create a different risk. If the return on savings does not keep pace with inflation, the money’s purchasing power may fall over time.

The FCA’s Financial Lives 2024 survey found that 61% of people with more than £10,000 in investable assets held at least three-quarters of those assets in cash. This does not mean investing would be suitable for everyone in that group. It does show why the purpose of the money, the time available and the person’s ability to accept losses all need to be considered. See the FCA’s Financial Lives findings.

For some people, keeping money in cash reflects a clear short-term need. For others, fear of loss, lack of knowledge or feeling overwhelmed may be preventing them from exploring options that could be relevant to longer-term objectives.

How to make more disciplined decisions

Recognising behavioural biases is useful, but awareness alone may not prevent them. Practical rules and a structured investment process can make it easier to pause before acting.

Start with a clear purpose

Define what the money is intended to achieve and when you are likely to need it. A retirement goal several decades away will usually require a different approach from money needed within the next few years.

A clear purpose provides a reason to look beyond today’s headlines. It also makes it easier to judge whether an investment remains relevant when markets change.

Understand risk and capacity for loss

Your attitude to risk describes how comfortable you feel with uncertainty and market falls. Your capacity for loss considers the practical effect a loss could have on your financial security and goals.

Both matter. Someone may feel comfortable taking risk but be unable to absorb a significant loss without affecting an important objective. Equally, someone may have the financial capacity to invest but feel unable to tolerate the fluctuations involved.

Diversify and rebalance appropriately

Spreading investments across different asset classes, sectors and regions can reduce reliance on any single holding or market. Over time, market movements can change the balance of a portfolio, so rebalancing may be needed to return it to the intended level of risk.

A diversified portfolio can still fall in value. Its purpose is to manage concentration risk, not eliminate uncertainty.

Introduce a pause before acting

A cooling-off period can help separate a considered decision from an emotional reaction.

Before making a significant change, you could write down:

• what has changed since the original investment was made;
• how the proposed action supports your long-term objective;
• what evidence challenges your preferred decision;
• what the tax, cost and diversification consequences may be; and
• whether you would make the same choice if markets had been calm that week.

This process does not dictate the answer, but it can reveal when urgency is being created by fear, excitement or social pressure.

Review the plan, not the headlines

Regular reviews are important because your goals, finances and circumstances can change. However, reviewing a plan is different from reacting to every movement in the market.

A scheduled review can focus on whether your objectives, timeframe, risk profile or income needs have changed. An additional review may also be appropriate after a major life event. In both cases, the aim is to assess suitability rather than chase recent performance.

How financial advice can help

An adviser can provide an objective perspective when emotions are running high. They can help you clarify your goals, assess your attitude to risk and capacity for loss, and build an investment strategy around your wider financial position.

Advice can also introduce accountability. Before changing course, you have an opportunity to revisit why the strategy was chosen, test whether your assumptions remain valid and understand the possible consequences of acting.

The FCA’s Financial Lives 2024 survey found that 87% of consumers who received advice said it was clear and understandable, while 85% said they were confident in it. These figures do not guarantee a particular investment outcome, but they indicate the value many consumers place on clear professional support. View the FCA’s advice market findings.

Build a plan around your goals

Successful investing is not about suppressing every emotional response or predicting each market movement. It is about creating a suitable process for making decisions when uncertainty is unavoidable.

By understanding behavioural finance, you can become more aware of the biases that may influence you. A clear plan, appropriate diversification, regular reviews and access to objective advice can then help you keep short-term emotions in perspective.

At DG Financial Services, we help clients build investment strategies around their goals, timeframe and wider financial circumstances. If you would like to review your current approach or discuss how your investments fit within a long-term financial plan, please contact our team.

THIS ARTICLE IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSTITUTE TAX, LEGAL OR FINANCIAL ADVICE. THE VALUE OF INVESTMENTS AND ANY INCOME FROM THEM CAN GO UP OR DOWN. YOU MAY GET BACK LESS THAN YOU INVEST. PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE. TAX TREATMENT DEPENDS ON INDIVIDUAL CIRCUMSTANCES AND MAY CHANGE.