Behavioural Finance Explained: How Investing Psychology Impacts Your Portfolio

Investing is often described as a numbers game: a world of ratios, charts and data. But the reality is more human. Beneath every trade lies an investor’s decision, and behind every decision is a mind full of emotions and (unfortunately) biases.

The concept of behavioural finance demonstrates that while markets are influenced by earnings reports, GDP figures, and political manoeuvres, they are also shaped by the feelings and behaviours hardwired into us through thousands of years of evolution, including fear, greed, and herd mentality. But does that mean our financial health is at the mercy of our innate humanity? Not necessarily. In this article, we’ll explain what behavioural finance is, outline the key concepts in investing psychology, and show how understanding these ideas can protect your portfolio from common mistakes.

Along the way, we’ll also highlight strategies to manage these pitfalls and point to the tools and resources that can help you invest with greater confidence.

What is behavioural finance?

At its core, behavioural finance is the study of how psychology influences financial decision-making.

Traditional finance assumes that investors are rational actors who process information efficiently and always act in their best interest. Behavioural finance challenges this view, pointing out that people are prone to cognitive biases, emotional reactions, and social influences that lead to irrational behaviour.

Some examples in action include:

• Stock market bubbles and crashes — Bubbles can form when herd behaviour and speculation push prices far beyond their underlying value, only to collapse when confidence falters. A classic example of this is the Wall Street Crash of 1929, when US stocks, inflated throughout the 1920s by cheap credit and investor optimism, plummeted in a wave of panic selling that wiped out fortunes and contributed to the onset of the Great Depression.
  
  
• Excessive trading — Overconfidence can tempt investors into excessive trading which in turn can raising costs and eroding returns. Barber and Odean (2000) demonstrated that frequent traders in the 1990s underperformed less active investors. The dot-com boom highlighted this vividly: many overconfident individuals rapidly bought and sold internet stocks at inflated prices, only to face substantial losses when the bubble burst.
  
  
• Under diversification — A well-diversified portfolio spreads risk across sectors, asset classes and regions, yet many investors fall into under-diversification, often through ‘home bias’. This narrow focus leaves them more vulnerable to local downturns and may mean they miss out on the benefits of global growth and balanced risk.

Behavioural finance helps us explain why markets sometimes act unpredictably and why many investors underperform benchmarks, despite having access to the same information and training.

The key concepts of investing psychology

Understanding the core concepts of behavioural finance can help you spot when emotions, rather than logic, are influencing your decisions.

Loss aversion

Psychology tells us that people dislike losing money much more than they enjoy making it. Because of this, investors often sell shares that have risen quickly to ‘lock in’ a gain but hold onto shares that are falling in the hope they’ll recover. In the long run, this habit can harm performance, as it involves selling good investments too soon while holding onto the bad ones.

Overconfidence bias

Some investors can overestimate their ability to forecast market movements or pick stocks that will outperform. Overconfidence can result in excessive trading, higher costs, and portfolios that lack diversification. It also explains why many individuals believe they can ‘beat the market’ despite evidence that the majority of active investors underperform broad indices.

Herd behaviour

Humans are social by nature, often finding reassurance in following the crowd—a behaviour that sometimes carries over into financial markets. Herding describes the tendency to mimic the actions of the majority (for example, buying when everyone else is buying, or selling when panic sets in). This behaviour has fuelled some of history’s most fascinating bubbles, such as the 2021 GameStop frenzy.

Recency bias

Recent events can carry disproportionate weight in our decision-making. After a period of strong market gains, investors may assume the trend will continue indefinitely, leading to risky overexposure. Conversely, after a downturn, they may grow overly pessimistic, selling assets just before a recovery.

Confirmation bias

Once an opinion is formed, investors sometimes tend to seek out information that supports it while ignoring contradictory evidence, resulting in tunnel vision that reinforces poor decisions and blinds them to the reality of changing fundamentals.

Anchoring

Anchoring occurs when investors fixate on a specific reference point, such as the price they paid for a stock, even when new information suggests it is no longer relevant. For example, an investor might refuse to sell a share trading at £80 because they originally paid £100, despite evidence that the company’s outlook has deteriorated.

Sunk cost fallacy

Linked to anchoring, this is the tendency to persist with a poor investment because you’ve already committed time or money to it. Rationally, only future prospects should matter, but emotionally, investors can struggle to walk away.

Mental accounting

Rather than treating money as fungible, investors may create arbitrary ‘buckets’ that shape their behaviour. Good examples of this are treating dividends as ‘free money’ to spend or keeping a separate ‘speculative pot’ without considering its impact on the overall portfolio’s risk profile.

How these biases can impact your portfolio

Panic-selling during downturns

Market volatility can trigger fear and loss aversion. During downturns like the 2008 financial crisis or the March 2020 pandemic, many investors sold in panic, locking in losses and missing the rebound. Panic-selling often turns a temporary setback into a permanent capital loss.

Chasing trends and bubbles

Recency bias and herd behaviour drive investors towards ‘hot’ stocks or sectors, often at inflated valuations. By the time most people pile in, much of the upside has already been realised. When the bubble bursts, late entrants suffer sharp losses (think tech stocks in 2000 or meme stocks like GameStop more recently).

Overtrading and high costs

Overconfidence bias can lead many investors to trade too frequently, as they assume they can outsmart the market. However, higher trading activity typically means higher costs, and research shows that frequent traders often underperform buy-and-hold investors once fees are taken into account.

Poor diversification

Anchoring and overconfidence can leave investors overexposed to a handful of assets or markets. For example, many UK investors suffer from ‘home bias’, putting most of their portfolio into domestic stocks and neglecting global diversification. If that sector or region suffers, the whole portfolio is at risk.

Abandoning long-term plans

Behavioural biases can cause investors to lose sight of their goals. A retirement investor with a 20-year horizon might abandon their strategy after a few bad quarters, crystallising losses and missing the long-term effects of compound interest.

Strategies to manage investing psychology pitfalls

Biases are part of human nature. Thankfully, there are practical steps you can take to limit their impact on your investments.

The following strategies are presented for educational purposes only, to illustrate common approaches investors use to manage behavioural biases. These are not personal recommendations and may not be suitable for your individual circumstances. You should consider your own situation and seek independent advice before implementing any investment strategy.

1. Build a written investment plan

Some investors find it helpful to define their goals, risk tolerance, time horizon and rules for entering and exiting investments. Writing this down can provide a reference point during volatile times, which may help reduce emotional decision-making.

Open an IG account today and set your objectives

2. Diversify across assets and markets

Diversification aims to spread risk, potentially reducing the impact of any one poor decision. This can involve investing across various asset classes, including equities, bonds, commodities, and different geographies. A balanced portfolio may help investors manage volatility without being overly exposed to one sector. However, diversification does not eliminate all investment risk or guarantee profits, and diversified portfolios can still experience losses.

Invest in over 2,000 ETFs with IG

3. Use risk management tools

Stop-loss orders, limit orders and trailing stops may help some investors enforce discipline and remove emotion from trade execution. However, these tools have limitations, may not execute at desired prices in fast-moving markets, and can lock in losses during temporary downturns.

For long-term investors, automated rebalancing can help maintain target allocations even when markets experience significant fluctuations, though this approach may incur transaction costs and tax implications.

Learn more at IG trading strategies

4. Keep a trading journal

Some investors choose to document their decisions, the rationale behind them, and their emotional state at the time. Over time, this record may highlight recurring mistakes and help them recognise when biases are influencing their decisions.

5. Automate where possible

Investors struggle with emotional decision-making, they may consider using managed portfolio services such as IG Smart Portfolios. These are professionally managed and regularly rebalanced, which may help maintain discipline without daily decision-making.

However, managed portfolios still carry investment risk, incur management fees that will affect returns, and past performance does not guarantee future results. Other managed portfolio services are available from various providers.

Learn more about IG Smart Portfolios

6. Continuously educate yourself

Understanding behavioural finance may help investors guard against its traps. IG Academy provides free courses and resources to help build investment knowledge. Educational resources are also available from various other providers and independent sources.

Explore IG Academy

Smarter decisions, stronger portfolios

Behavioural finance shows us that investing is more than numbers: it’s psychology.

From overconfidence to herd behaviour, biases can distort decisions and erode returns. However, by recognising these patterns, building a plan, and using tools to manage emotions, you can enhance your chances of achieving long-term success.