Understanding your personal biases can help you form investment strategies that work for you across good times and when the going gets tougher
Traditional finance theory starts from the principle that markets and their investors are perfectly rational. A quick look around will convince you that such an idea is optimistic to say the least. Rational markets would not fluctuate without any apparent reason, nor would rational investors feel the pain of a loss over twice as much as they enjoy the feel of equivalent gains.
The field of behavioural finance, which studies the impact of investor psychology on financial decisions, has developed in response to the inconsistencies between rational theory and irrational, human, reality.
Behavioural finance can offer lessons to all investors. People can act in surprising ways in all sorts of circumstances. For instance, you might ask yourself if you recognise any of these behavioural finance biases in yourself or others:
Overconfidence: Many people when asked identify themselves as ‘above average’, whether in terms of driving ability, intelligence or looks. By definition that cannot be true – no more than 50% can be above average. Overconfident investors can pay a high price to learn this truth.
Hindsight bias: How many times have you heard someone say “I always knew that was going to happen” after the event has happened? Yet the same person probably never warned you beforehand. People like to imagine their predictive powers are good – and some can convince themselves their hindsight was once foresight.
Herding: “Everybody is investing in technology/emerging markets/commercial property/etc., so I will too.” It seems the easy option, not least because human beings are inherently fearful of going against the crowd. However, the crowd’s judgement is not always right. Also, if and when the crowd changes its mind, the reversal can become a dangerous stampede, especially in investment markets.
Confirmation bias: Which do you pay more attention to, the information and comments that reinforce your views or those that contradict them? The natural response is the former, something that some people on social media have learned to exploit. However, when it comes to investment, hearing only what you want to hear could mean ignoring important if uncomfortable truths.
Self-attribution: You choose to invest in X and its value rises – that is proof of your skill. Then you choose to invest in Y and its value halves – that is just bad luck. Such a view of expertise makes us feel better about both outcomes, but it could be pure self-deception. It is also possible that the choice of X was down to luck and Y to lack of investment skill.
By developing an understanding of behavioural finance ideas, you can identify your own investment behaviours. The nearer you come to acting like a rational investor, the more you may be able to benefit from the irrationality of others.
A sensible starting point is to identify your innate biases and take advantage of the professional, objective advice we can offer when making investment decisions.
The value of your investments, and the income from them, can go down as well as up and you may not get back the full amount you invested.
This article is for general information purposes only.