Behavioural finance is the branch of behavioural economics that focuses on finance and investment. It encompasses elements of psychology, economics, and sociology.
Behavioural finance has gained increased prominence since Daniel Kahneman was awarded the Nobel Prize for economics in 2002. (Kahneman was recently involved in analysis of the regret-proof Portfolio.)
Kahneman is best known for identifying a range of cognitive biases in his work with the late Amos Tversky. These biases, and heuristic (which are mental shortcuts we take to solve problems and make judgments quickly), are consistent deviations away from rational behaviour (as assumed by classical economics).
Richard Thaler, also awarded a Nobel Prize, has made a large contribution to Behavioural Economics, his work has had a lasting and positive impact within Wealth Management.
There is a continued drive to better understand how our behaviour affects the decisions we make.
From an investing perspective, failing to understand our behaviour can come with a cost. By way of example, the cost could be the difference between the returns on an underlying investment and the returns received by the investor.
In short, we have behavioural biases and are prone to making poor decisions, investment related or otherwise. Therefore, it is important to understand our behavioural biases. Behavioural Finance can help us make better investment decisions.
There are lots of good sources on Behavioural Finance, none other than from Joe Wiggins, whose blog, Behavioural Investment, provides clear and practical access to the concepts of Behavioural Finance.
By way of example, Joe has recently published “A Behavioural Finance Toolkit”. This is well worth reading (Behavioural Finance Toolkit).
The Toolkit helps us understand what Behavioural Finance is and then identifies the major impediments to making effective investment decisions.
These impediments are captured in the “MIRRORS” checklist outlined below:
As the Toolkit outlines: “An understanding of our own behaviour should be at the forefront of every decision we make. We exhibit a number of biases in our decision making. While we cannot remove these biases, we can seek to better understand them. We can build more systematic processes that prevent these biases adversely influencing the decisions we make.
Investors should focus on those biases that are most likely to impact their investment decisions – and those supported by robust evidence. We have developed a checklist to reduce errors from the key behaviours that affect our investment decisions – ‘MIRRORS’.”
|M||Myopic Loss Aversion||We are more sensitive to losses than gains, and overly influenced by short-term considerations.|
|I||Integration||We seek to conform to group behaviour and prevailing norms.|
|R||Recency||We overweight the importance of recent events.|
|R||Risk Perception||We are poor at assessing risks and gauging probabilities.|
|O||Overconfidence||We over-estimate our own abilities.|
|R||Results||We focus on outcomes – the results of our decisions – when assessing their quality.|
|S||Stories||We are often persuaded by captivating stories.|
The Toolkit provides detail on each of these impediments.
Risk Perception is the big one for me, particularly the ability to gauge probabilities and to effectively probability weight risks.
This is vitally important for investors and for those that sit on Investment committees.
Identifying risks is relatively easy, we tend to focus on what could go wrong.
As this The Motley Fool article highlights, being pessimistic appears to sound smart, and being optimistic as naïve. As quoted in the article: John Steward Mill wrote 150 years ago “I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.”
Albeit, in truth, assigning a probability to a risk, the likelihood of an event occurring, but also its impact, is a lot more difficult than merely stating a “potential” risk.
Remember, “more things can happen than will happen” – attributed to Elroy Dimson who also said “So you manage risks by comparing them to potential returns, and through diversification. Remember, just because more things can happen than will happen doesn’t mean bad things will happen.”
The Toolkit highlights that Noise affects our decision making.
“Our decisions are affected by noise; random fluctuations in irrelevant factors. This leads to inconsistent judgement. Investors can reduce the effects of noise and bias through the consistent application of simple rules.”
As quoted “Where there is judgement, there is noise, and usually more of it than you think” – Kahneman
Accordingly, the Toolkit offers six simple steps to improve our decision making; three dos and three don’ts.
- Do have a long-term investment plan.
- Do automate your saving.
- Do rebalance your portfolio.
- Don’t check your portfolio too frequently.
- Don’t make emotional decisions.
- Don’t trade! Make doing nothing the default.
The central point: “These six steps seem simple but are not easy. We cannot remove our biases, or ignore the noise. Instead, we must build an investment process that helps us overcome them.”
There is a lot of common sense in the six steps outlined above.
Finally the Toolkit outlines four books that have changed the way we think about thinking!
I’d like to suggest a couple of books that I value highly, which are on topic, and with a risk focus angle as well:
- The Undoing Project, A Friendship That Changed Our Mind, Michael Lewis, this book outlines the relationship between Kahneman and Tversky, and the collaboration they had in developing their theories, including highlighting the different experiments they undertook. In doing so, Lewis provides practical insights into the types of biases we have in making decisions.
- Against the Gods, The Remarkable Story of Risk, Peter L. Bernstein. True to its label this book provides a history of the perception of risk and its management over time, right up to modern times, emphasising: more things can happen than will happen!
Both books provide fascinating accounts of history.
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