- Investment management
- 5 minute read
You could get a better return on your money if you learn some important lessons from behavioural finance theory
Psychology teaches us that humans are imperfect information processors who are subject to bias, error and perceptual illusions. Surely it is to be expected then, that our investment decisions should also be subject to bias, error and perceptual illusions? The theory of behavioural finance would argue that this is so, with the central lesson being that psychology actually permeates the entire financial landscape.
Standard finance theory states that investors are rational, markets are efficient and expected returns are determined only by risk. On the other hand, behavioural finance theory treats investors as normal and markets as inefficient, with expected returns being determined by more than just risk - emotional factors play an important role, for example.
In practice, this means that even when we believe that we are making logical, rational decisions, emotions such as fear and greed can override and jeopardise our smart investment choices. So what can we do to overcome these destructive emotions?
Be conscious of cognitive biases
Behavioural finance acknowledges that investors suffer from a variety of cognitive errors that can have a negative impact on their investment decisions. A study published in the British Medical Journal in 2014 showed that doctors could change a patient’s mind about undergoing a surgical procedure according to how they frame the recommendation. Patients were much more likely to opt for surgery when told that they had a 90% chance of survival, rather than a 10% chance of mortality.
Similarly, in investing, it is possible to frame data to make it look positive or negative. So, while analysing hard data is important, we should be conscious of how it is presented and how we frame it in our own heads. Evidence shows that a person’s subjective confidence in his or her judgements is reliably greater than the objective accuracy of those judgements. This results in overconfidence errors. When surveyed, people typically rate themselves ‘above average’ on positive traits such as driving ability, employment prospects or life expectancy. Investment ability is no different. Fortunately, ensuring that a portfolio is well diversified is a good way of mitigating the effects of poor decision-making that are caused by overconfidence bias.
The pressure to confirm with our social group means that we can also fall prey to herding errors. We have a tendency to mimic the actions of a larger group, regardless of whether those actions are rational or irrational, due to the common rationale that it is unlikely that a large group could be wrong. Yet, the reality is that investments that are popular with many people can easily become overvalued due to over-optimism, making them ultimately poor value. Herding errors are more likely to occur when we have little or no experience. It has been suggested that the dot-com bubble, which burst in 2000, occurred in part due to herding errors. Investors followed the flock and made decisions without having enough insight.
Losses loom larger than gains
In addition to cognitive biases, emotions can also affect investment decisions. To follow the principles of good investing (diversify, stay liquid, buy low and sell high), we must be emotionally prepared. Yet history has shown us that, despite understanding these principles, we have a tendency to buy high and sell low. Think of the enthusiastic investors who entered the markets when they were peaking in November 2007, only to sell in a blind panic in March 2009 when they reached their pit. Greed can drive up share prices when market conditions are buoyant, but fear can result in a freefall when the markets dip.
Ultimately, fear and greed can both win over the rational, long-term view that we should take when investing. The fear of losing all our money is explained by psychology and behavioural economics as ‘loss aversion’ – the disproportionate dislike of losses compared with seeking equivalent gains. In 1979, psychologists Daniel Kahneman and Amos Tversky summed up this attitude with the phrase, “losses loom larger than gains”. It could lead the once enthusiastic investor described above to sell at a low, or even prevent other investors from investing at all. While fear of loss could drive this behaviour, so, too, could the greedy instinct to keep hold of our money.
In addition, the fear of missing out can also lead to sub-optimal investment decisions. The prospect of growing wealth when markets are on the up can result in the fear that we will miss out on a big win, prompting eager investors to jump in without weighing up the risks. Parallel to this comes the sense of greed that drives us to make more money.
Although it seems that we must overcome an insurmountable list of psychological biases and emotions, all is not lost. We may be imperfect information processors, but we do not have to be hopeless investors. By taking the time to understand that we are all subject to cognitive biases, we go halfway to reducing the errors associated with them. Furthermore, we can avoid the negative impact of our emotions through a combination of self-education and delegating our investment decisions to professionals.
A financial planner can educate you in the principles of investing and support you to make the right choices with your money. As well as applying their professional expertise and experience to help you achieve your investment objectives, your adviser will take an objective view of the long-term plan they have put in place for you, which will prove invaluable when your emotions try to take over. Timely communication and action from your adviser can also go a long way in allaying any fears that arise as a result of volatility in the markets or changes to your circumstances.
So, whether you are investing your own money, relying on a trusted adviser, or both, you can learn lessons from behavioural finance that will make you a smarter investor overall.