We’re hard-wired as human beings to think in the opposite way to what a good investment strategy should be and this can result in investment portfolios underperforming by up to 4 per cent a year, according to independent expert Dalbar.
But by understanding the mental processes that drive our actions, we can plug this behavioural gap.
Behavioural finance sees investors as complex bundles of emotion and biases, rather than calm, rational individuals. A leading proponent, the US economist and Nobel Laureate Robert Shiller described it as a counter-revolution to mathematical finance, which does see people as calm, rational and analytical agents. Shiller used his understanding to predict the dotcom crash and financial crisis.
Here are some of the basic themes of behavioural finance, but be warned: ticking them off one at a time isn’t the best approach. It’s important to understand how they interact with each other.
Getting hyped by small passing trends
Sometimes a story creates its own momentum. The challenge is to stay focused on what really matters, rather than getting caught up in the latest fad.
Whether it’s something you read on the web or something your friend recommends, you hear little nuggets all the time and you
become emotionally engaged. Shares enjoying strong rises tend to gather this kind of attention, helping to create bubbles.
Once investors are emotionally engaged, overconfidence becomes a danger. This means they will limit their research to things that back up their predisposed position, and therefore end up underestimating the risks.
Shiller and others consider overconfidence a main factor behind bubbles: it helps people believe house prices or stocks will inevitably rise, no matter what others say.
People are naturally loss averse. They don’t feel gains compensate for the chance of an equally-sized loss. But in finance we can’t avoid losses.
So beware of investment platforms that display gains and losses based, for example, on daily price movements. All they give is a sense of risk and no sense of return. Very few people invest for a daily return; they’re investing for their financial futures over many years. What these platforms do is frame returns in a way that triggers loss aversion and heightens risk perception.
The latest events tend to dominate our minds. So, when markets fall, our risk perception rises, but as time passes, the pain will lessen.
Take two people, both with the same return, but where one has experienced a strong gain followed by a loss, and the other a loss followed by a gain. I’m going to have two very different conversations – even though traditional mathematical finance would say that they got exactly the same return, so they should be equally happy.
In times of stress, the human psyche prefers action to inaction. This means investors tend to do the one thing that exercises absolute control – sell.
But often the best advice is to follow the principles of good portfolio management and rebalance a portfolio, rather than selling everything.
The disposition effect
This is a behaviour shown to cost a lot of money. Investors are much happier to sell winning positions over losing ones. It’s a great ego boost. It gives them the sense that their investment did what it was supposed to do, because they made a profit. But in selling a loser, loss aversion kicks in, creating emotional pain. So they don’t.
You end up holding the losers too long and selling the winners too early. When you look at what happens over a 12-month period, you’ll often see people would have done better by selling the losers and keeping the winners.