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Behavioural Finance: Understand why you don't invest rationally and what you can do about it

Updated on March 4, 2015
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Cruncher is the pseudonym of an actuary working in London with experience in Insurance, Pensions and Investments.

Most theories about finance and investment assume that people invest rationally to make the best return they can subject tot he amount of risk they are willing to take with the most efficient mix of capital returns and income. But as we all know from our own lives, if we are truly honest about it, this doesn't always (or maybe ever) happen.

Even professional investors have been shown to behave irrationally, making decisions based on emotion rather than cold logic. Behavioural finance is the subject that tries to explain why this happens.

There are number of different ways in which your decision making brain can play tricks on you, either through dumb luck or when manipulated by the unscrupulous. It's worth understanding these so that you are forearmed for when they happen to you.

Don't let falling returns get you down!
Don't let falling returns get you down! | Source

Financial anchoring

This is a fancy term for the tendency we all have to think of things in relative terms, by comparing what we are considering to an "anchor". This could be the most recent thing we have seen (the "recency effect") even if that recent thing was totally irrelevant. Studies have shown that you might easily subconsciously decide a share was expensive or cheap relative to the score in a cricket you are watching.

More subtly we can be anchored to previous information (such as the share price when we bought the share) and think only relative to that, rather than considering the situation afresh as it is today. All too often we stick with bad investments because we still stick too closely to the "anchor" price at which we bought them, instead of cutting our losses when we can.

Question framing

This trick has long been known to marketers and pollsters. People will answer the same question very differently depending on the context. If you set up the previous questions and the tone and wording of the question just right you can manipulate people into answering a certain way. It is not 100% percent of course, but it is noticeable.

It works partly because we naturally respond the emotional subtext of questions as well as the text. This is really useful in social situations, but a bit less so when making cold hard investment decisions.

Sir Humphrey teaching us how question framing is done.

Prospect theory

Prospect theory suggests that in reality people behave differently towards gains and losses. In theory we ought to treat avoiding a loss the same as a gain and vice versa, but it doesn't feel like that in real life.

Prospect theory holds that investors are risk averse when it comes to gains - they want to keep what they have. But risk seeking when it comes to losses. They would rather try to make back what they lost or take a risk to avoid a loss in the first place, than cut their losses and move on.

Investor behaviour and ultimately their returns are really affected by perceptions of losses vs gains, which can be affected by how the information is framed (just like in question framing above). Our emotional reactions to investment outcomes are not rational.

Once you've got it, you really don't want to let it go
Once you've got it, you really don't want to let it go | Source

Myopic Risk Aversion

People will often refuse to accept the risk of small losses in the short term, even if it means they would expect to do better in the long term and even if they have plans to use the money in the short term. It is really hard to accept losing your hard earned cash you have invested, but only by being willing to do so can you get the extra returns from long term investing. it is precisely those volatile assets that have higher returns - because supply and demand mean that unpopular volatile assets pay a higher return (it's a trade off between risk and return yet again).

Overconfidence

Around three quarters of people think they are a better than average driver. Clearly they can't all be right! But people do systematically overestimate their abilities to do things and underestimate the difficulties and costs.

This can be a positive thing if it keeps you getting out of bed in the morning. But it can be a disaster for your money if you think you are clever enough to beat the market when you are not.

Don't worry about feeling stupid. It's better to acknowledge your limitations than to actually do something stupid.
Don't worry about feeling stupid. It's better to acknowledge your limitations than to actually do something stupid. | Source

Behavioural finance is an important tool for an investor. Knowing about these mistakes doesn't mean that you will never commit them. But it does give you a chance to manage yourself better if you know these risks are there. And that gives you chance to be more rational and so more like the "ideal investor" is supposed to be.

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