Behavioural Finance

Economic theory had for centuries blindly assumed that the common man was a rational being in perpetual possession of perfect information. Behavioural Finance is the strike-me-down-Judy body of knowledge that admits people are not and do not. Many financial professionals had of course known for a long time that his fellow kind did not fit quite so well into the professors’ neat model, though the finding genuinely seems to have taken parts of the academic world by complete surprise.

Nonetheless, for us the use of academia’s new favourite is diagnostic. Behavioural Finance names and shames many of the potential “biases” that can afflict the investor. And awareness is the first step towards remedy. A bias is a departure from rational decision making: humans often have great difficulty in seeing both sides of an argument, and that can have a detrimental impact on investment results. Biases fall into two camps: the cognitive and the emotional. Cognitive biases arise because our brains are faulty computers. Emotional biases exist because we get scared, greedy, and sometimes just plain stupid.

Starting with the cognitive, I am sorry to tell you that your brain has some information processing problems. If it was an iMac you would demand a full refund. The “framing bias”, for example, results in a different answer depending on how a question is phrased. PhD students are more likely to register early if there is a penalty late fee than if there is a discount for early registration, even though the financial costs are identical. The “availability bias”, on the other hand, weights an answer by how easily it comes to mind. Your brain is a partially-complete library with the archive section behind a bolted door. It is unsurprising, for example, that when asked to rate the probability of a variety of causes of death, participants give excessive weightings to the more “newsworthy” events like aeroplane crashes or terrorist attacks.

We also tend to cling stubbornly to our existing beliefs, even in the face of new information. The “confirmation bias” makes us dismiss anything that contradicts our beliefs, and instead actively seek data to support our view. We form a view, close our eyes, stick fingers in our ears, and sing “la la la”. The remedy for such cognitive errors is methodical hard work that constantly seeks out opposing views, and bases decisions in cold fact and reason.

Emotional biases are much harder to remedy. “Loss aversion” is the inclination to hold your portfolio losers to avoid banking a loss, and sell your portfolio’s winners to crystallise a small gain, regardless of an investment’s current attractiveness. A rational investor should disregard the current profit or loss figure, but focus instead on the future prospects of the investment. Elsewhere, the “overconfidence bias” gives us undue faith in our own abilities, and can lead to excessive risk taking. We are not only faulty, but thoroughly convinced that we are fantastic.

Remember that we are built for survival on the savannah, not patient and diligent investment decision making. However, only by being aware of the many types of faults to which we are all inclined can we seek to mitigate them. There are many tools available to lessen these biases, though all have a common theme: that of a disciplined approach backed up with thorough and detailed research.

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