Humans are complex beings whose decisions aren’t always based on objective or purely rational thought. Nowhere is this more obvious than in the world of investments. We may believe we are capable of being entirely rational in our financial decision-making, but the reality is that emotions quite often get the better of us. When people invest, their decisions are likely influenced by a number of biases that can have a dramatic effect on outcomes. Understanding these biases, which are collectively known as behavioural finance, can help people to make better investment decisions.
Defining behavioural finance
Many professional investors believe in what is called modern portfolio theory, which underpins a significant amount of decision-making in the investment world. Many of the principles in modern portfolio theory date back to the 1950s and 1960s .
There is a fundamental belief that financial markets are efficient, investors make rational decisions, and that market participants are sophisticated, informed and act only on available information.
Behavioural finance turns those ideas on their heads. Rather than view the investment world as being perfect and orderly, behavioural finance accepts that investors make irrational decisions, and stocks can have unjustified prices. In short, investor decisions can be clouded by any number of biases and factors.
Know your cognitive biases
People quite often make the same errors time and time again without realising it, which can have a negative impact on their investment portfolios. The first of these is known as narrow framing, which is what happens when people define their choices or their criteria too narrowly and fail to see the bigger picture. For example, this can involve focusing on an investment’s short-term volatility and potential for loss, rather than its long-term potential to make attractive investment returns. By looking at only a specific timeframe, investors can fail to see the bigger picture and miss out on better investment returns.
Loss aversion is another major stumbling block for the average investor. While it is fair to say most investors are attracted to positive investment returns, the fact remains that many are held back by the notion that the fear of loss looms larger than gains. Experiments have found that the pain of losing hits investors twice as hard psychologically than the pleasure of making investment gains. This explains why we feel so bad when we lost £5 in the street, compared with the feeling of finding the same amount of money on the floor.
It’s not just fear of loss or volatility that can lead investors astray; the desire to follow the crowd, also known as herding, may feel rational because we think a large group can’t be wrong. However, in reality, this can cause investments to become over-valued and result in negative outcomes. History is replete with examples of investors who have rushed to invest in the next big thing, from tulips to dotcoms. In nearly every case, the bubble burst and investors ate their losses.
There are many other cognitive biases in addition to these that can affect the decisions you make, the common thread among them is that they cause us to make mistakes that can prove detrimental both in the short and long term. There is hope, however. Once we acknowledge that the cognitive biases exist, it is possible to put in place processes to guard against it and reduce our tendency to make errors and achieve better results.
This also highlights the importance of seeking high-quality financial advice. Wealth managers not only want the best outcomes for their clients, but they also approach investing from an objective and professional perspective. Your portfolio forms part of your long-term financial plan, with each investment decision based on qualitative and quantitative data, rather than emotional factors, so that it has the highest probability of meetings its objectives.
If you would like to discuss your financial planning, please get in touch using the contact form here.