24 Mar Tech Talk: The link between behavioural finance and investments
Why managing our emotions leads to better investment outcomes.
Behavioral Science: An Overview
Classic economics assumes that investors are rational — that they incorporate available information to determine appropriate probabilities and to optimize their investing decisions.
But, what you may not realize is that 95% of us use heuristics, or mental shortcuts, such as a rule of thumb (general guidelines say this is the right thing to do), an educated guess (this seems like the right thing to do) or intuitive judgment (it feels right) to make complex decisions. The study of behavioural science, which incorporates cognitive and behavioural psychology, recognizes that investors are emotional and have biases that often may lead to erroneous conclusions and suboptimal investing decisions. And there are several common biases that many investors face, which can lead to poor investment decisions.
Behavioural biases can influence how we process and interpret information. They can also influence how we make decisions and take information in. In Behavioral Science, these are often called Cognitive Biases and Emotional Biases. Here you will find some common behavioural biases that can have a negative impact on investors’ financial decisions.
Theories in Practice
In order for investors to help improve their individual investment outcomes, they need to improve the choices they make. Understanding biases in context can help all of us make better investment decisions.
Recency Bias in Context:
Investors often look at recent returns when making important financial decisions. After all, it’s easier to emotionally validate a choice when we are following a trend along with everyone else. This behaviour can cause us to chase performance and lead to buying high and selling low. As this hypothetical example shows, when emotions take over it’s easy for investors to make suboptimal decisions, tending to buy out of excitement when the market is going up and sell out of fear when the market is falling.
Familiarity Bias in Context:
One common familiarity bias is called “home-country bias,” which is the tendency to favour companies in one’s own country over those from other regions and countries. For the Aussie investor, there’s a good chance a sizeable portion of your portfolio is invested in Australian companies. Where in fact, the Australian stock market only accounts for around 2.5% of the global market (via Credit Suisse).
Mental Accounting Bias:
Mental accounting bias can occur when you spread investment assets across several accounts. When investors put money in different buckets or similar accounts, oftentimes those dollars are not invested properly to meet long-term goals. As a result, investors may miss out on returns they may have otherwise achieved if the money had been properly invested according to time horizon and risk tolerance strategies.
Behavioural Finance: How to Move Beyond the Biases
Keeping emotions in check can be a challenge. Market volatility is uncomfortable; Combine that with a 24/7 news cycle and even the most seasoned investors may feel unnerved. A basic understanding of behavioural finance can help you keep emotions in check, make better decisions and achieve potentially superior investment outcomes. Partnering with a financial advisor can help, too, as she or he can often develop a thoughtful strategy, provide continued advice to ensure discipline in investment choices.
If you would like to know more, talk to Michael Sik at FinPeak Advisers on 0404 446 766 or 02 8003 6865.
This article was produced with reference to PIMCO and may not be the expressed views of FinPeak Advisers, (click here to view the full article).
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