Are you a rational Investor?

24th June 2013

There is much discussion and debate in the investment world among fund management companies, psychologists and investment advisers regarding the subject commonly known as ‘Behavioural Finance’. So what is it and why should you be aware of it?

What is Behavioural Finance?

Behavioural Finance is a field of study which attempts to identify, understand and explain the human psychological and emotional factors that influence investors reasoning and decision making process. If we do not apply rational perspective when investing, we leave ourselves vulnerable to the impact of our own emotions, which may mean investing on an irrational gut instinct rather than underlying facts or fundamental principles.

Some of the reasons

Many investors base the price they are willing to pay for an asset on their perception of its immediate potential, focusing on short term newsflow and forecasts. However, these factors distract from the fundamentals, preventing the investor from viewing the investment as a long-term asset. This means that decision making is often based on irrational impulses, fuelled by common human psychological traits which cause us to form several kinds of emotional or cognitive biases, some of which are listed below:

Anchoring – Our tendency to rely too heavily on one specific piece of information, such as the price a stock use to be and so we assume it will get back to that point again.

Confirmation Bias – Where we only pay attention to information which supports our existing view, and discount anything which opposes it.

Overconfident Bias – An overly optimistic assessment of our own knowledge or abilities (often fed by Hindsight Bias – believing after an event that we could have predicted the outcome or “I knew it all along” bias).

Herd Behaviour – Where we follow the actions of the group, even if individually we may have recognised their actions as irrational, this is surely evident in the way markets always over-react to either good news or bad news then usually steadies out over the next few weeks. A good example of this, has to be the DotCom boom, surely with so many IT companies not even making a profit back then, it must have been obvious that to invest was an irrational herd mentality? It all seems obvious now in hindsight.

Behavioural Finance Affects Markets

Theories in ‘traditional’ finance, such as ‘Efficient Market Hypothesis’ (EMH) which asserts that markets are fully efficient and cannot be beaten as asset prices reflect all relevent information which is known by all buyers and sellers at all times, assumes that investors always behave rationally and logically. We know that this is not true of human nature.

Behavioural Finance identifies that people systematically make errors of judgement when they form investment decisions. When these mistakes become repeated throughout the investment community, they cause illogical price movements in assets. Such inafficiencies can offer a window of opportunity to those who recognise what is driving these price movements, and develop strategies to exploit them.

A notable episode of behavioural finance at play came in 2011 when an earthquake and tsunami hit Japan. While it could be expected that Japanese equity markets would fall after the disaster, European equity markets dropped equally as sharp – even though investors had little information on the likely impact of such a far-flung event on, for example, German companies.

How can Understanding Behavioural Finance help investors?

The principles behind behavioural finance sound straightforward enough, but how can they be used to construct and manage an investment portfolio?

One approach is to be objective and investigate scientifically how much you are being paid to invest in a particular asset. By comparing the yield provided by say, a government bond to that of a company share, an investor can objectively evaluate the relative attractiveness of each asset. However, this process has to be disciplined; the investor cannot be swayed by the sentiment surrounding each asset. In other words just because everyone is selling commodity funds at the moment or buying gold should not have any effect on your final decision.

Not every investor will be comfortable with following the rules of behavioural finance techniques. It can feel very lonely and as if you are being a bit risky when taking decisions that fly in the face of the norm (or should I say, not following the herd)

Nevertheless, the principles of behavioural finance can be harnessed by any investor willing to accept that a sizeable proportion of market movements can be attributed to noise rather than hard facts.

Ultimately, behavioural finance does not seek to ignore the human factor. Rather, it seeks to recognise it, acknowledge it’s important influence, and then strip it out of the analytical process in order to make successful long term investment decisions. After all, wouldn’t it be nice to have been invested in something from the beginning of it’s rise (such as gold) as oppose to be jumping on the band-wagon and following the herd because you read in the Daily Mail how everyone is investing in it and believing all the hype that it protects you against inflation!