Behavioural finance - An opportunity for smart investors

Posted by Stephen Sutherland on Tue, Jul 03, 2012 @ 01:22 PM

Behavioural investing for smart investorsUnderstanding your financial personality is vitally important. It can help you understand why you make the investment decisions you make, how you are likely to react to the uncertainty inherent in investing and how you can temper the irrational elements of investment decisions while still satisfying your individual preferences.

Most people know that emotions affect investment decisions. For instance, people in the world of investments commonly talk about the role greed and fear play in driving stock markets. Behavioural finance extends this analysis to the role of biases in decision making, such as the use of simple rules of thumb for making complex investment decisions. In other words, behavioural finance uses psychology to understand how people make investing decisions.

Helping you make better investment decisions

Behavioural finance is of interest because it helps explain why and how markets might be inefficient, providing opportunities for smart investors to potentially profit. This is the first in our new series of blogs focusing on the topic of ‘behavioural finance’.

We’ll begin with the concepts behind behavioural finance and move onto discussing how the presence of regularly occurring anomalies (irregularities) in conventional economic theory became a big contributor to the formation of behavioral finance. These so-called anomalies, and their continued existence, directly violate modern financial and economic theories, which assume rational and logical behaviour.

Also in this series of posts we'll look at five key concepts found in behavioural finance, including anchoring, framing, hindsight basis, herd behaviour and overconfidence. By the end of this series, I hope that you'll have a better understanding of some of the irregularities that conventional financial theories have failed to explain. In addition, I hope you gain insight into some of the underlying reasons and biases that cause some people to behave irrationally (and often against their best interests). Hopefully, this newfound knowledge will give you an edge when it comes to making better investment decisions.

An introduction to Behavioural finance

The academic field of finance has long had a behavioural side. One of the classic examinations of irrational investor behaviour, ‘Extraordinary Popular Delusions and the Madness of Crowds’, dates back to the 19th century. In the 1930s, legendary economist John Maynard Keynes and value-investing guru Benjamin Graham emphasised the effect of investors' emotions on stock prices. More recently, money manager David Dreman published ‘The New Contrarian Investment Strategy’ in 1982, which argued that investors could outperform by not following market fads.

Ways of analysing investment performance

The financial theory based on ‘Modern Portfolio Theory’ (MPT) (Markowitz, 1952) and ‘Capital Asset Pricing Model’ (CAPM) (Sharpe, 1964) has long shaped the way in which academics and practitioners analyse investment performance. The theory is based on the notion that investors act rationally and consider all available information in the decision-making process, and hence investment markets are efficient, reflecting all available information in security prices.

However, researchers have uncovered a surprisingly large amount of evidence of irrationality and repeated errors in judgement. The field of behavioural finance has evolved in an attempt to better understand and explain how emotions and cognitive errors influence investors and the decision-making process. Kahneman and Tversky (1979), Shefrin and Statman (1994), Shiller (1995) and Shleifer (2000) are among the leading researchers that have utilised theories of psychology and other social sciences to shed light on the efficiency of financial markets as well as explain many stock market anomalies, bubbles and crashes.

People frequently behave irrationally

One of the most rudimentary assumptions that conventional economics and finance makes is that people are rational and seek to increase their own well-being. According to conventional economics, emotions and other extraneous factors do not influence people when it comes to making economic choices and investment decisions. In most cases, however, this assumption doesn't reflect how people behave in the real world. The fact is people frequently behave irrationally. Consider how many people purchase lottery tickets in the hope of hitting the big jackpot.

From a purely logical standpoint, it does not make sense to buy a lottery ticket when the odds of winning are overwhelming against the ticket holder (roughly 1 in 14 million for the National Lottery jackpot). Despite this, millions of people in the UK spend week in, week out on this activity. These anomalies prompted academics to look to cognitive psychology to account for the irrational and illogical behaviors that modern finance had failed to explain. Behavioral finance seeks to explain our actions, whereas modern finance seeks to explain the actions of the ‘economic man.’

Although behavioral finance has been gaining support in recent years, it is not without its critics. Some supporters of the efficient market hypothesis, for example, are vocal critics of behavioral finance.  The efficient market hypothesis is considered one of the foundations of modern financial theory. However, the hypothesis does not account for irrationality because it assumes that the market price of a security reflects the impact of all relevant information as it is released.

In our next post

In our next post on behavioural finance we'll look at anomalies at they affect investors decsions and the stock market.

Please note past performance should not be used as a guide to future performance, which is not guaranteed. Investing in Funds should be considered a long-term investment. The value of the investment can go down as well as up and there is no guarantee that you will get back the amount you originally invested.


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Topics: ISA investing tips, Investment strategy, Behavioural Investing