I’m proud to say that David Mountain, an ISACO client and engineer was one of the many people that loved my new book, How to Make Money in ISAs and SIPPs.
In his review, David said:
“I guess the part of the book I most enjoyed was ‘Chapter 9: Beyond Greed and Fear’ – I found myself saying ‘that’s me’ and I can fully recognise this behavioural finance, which is a very interesting subject. I would rate the book with 5 stars. “
David wasn’t the only person to like Chapter 9. Ray Hughes, another ISACO client, entrepreneur and private investor said:
“I was delighted to see that Stephen also covered the psychology of investing within Chapter 9. In my opinion, as a more seasoned investor, this is one of the critical aspects that an investor must understand if they are going to be successful in the markets.”
Another person who loved that chapter Andrew Tait, a business owner and client of ours had this to say about it:
“I particularly enjoyed Chapter 9 on investor behavior, seeing my past self in the descriptions of how we can act irrationally when investing.”
And so because Chapter 9 was so popular, I thought it best to run a series of articles taken from the chapter to see what you think. This is article number one in the series.
Would you like to join these early reviewers of my book? To download a ‘review copy’ – for free – prior to its publication, please just click here.
Excerpt below taken from Chapter 9, How to Make Money in ISAs and SIPPs
Beyond Greed and Fear
In this chapter we are going to look at how understanding behavioural finance can help you make better investment decisions and the process starts with getting a good grip on your financial personality. The key is to try becoming aware of the decisions you make and how you are likely to react to the uncertainty that comes with investing in the stock market. Understanding your financial personality can also help to control the irrational and illogical elements of your investment decisions.
Human nature usually serves us well in coping with day-to-day life. But it can also get in the way of achieving success in long-term activities, such as saving and investing. There is no cure for human nature, but a greater awareness of investment psychology can help you avoid major pitfalls.
According to accepted financial theory, human beings are rational (of sound mind). However, researchers have uncovered a surprisingly large amount of evidence that this is frequently not the case. Dozens of examples of irrational behaviour and repeated errors of judgment have been documented. The late Peter L. Bernstein wrote in ‘Against The Gods’ that the evidence ‘reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty’.
Behavioural finance = investment psychology
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 spoke of the effect of investors' emotions on stock prices. More recently, in 1982, money manager David Dreman published ‘The New Contrarian Investment Strategy’, which argued that investors could outperform by not following market fads.
Modern portfolio theory is nonsense
The financial principles based on Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM) have long shaped the way in which many investors judge investment performance.
The theory is based on the belief that investors act rationally and consider all available information in the decision-making process and as a result, investment markets are efficient and have factored all available information into the prices of investments. However, researchers have uncovered a surprisingly large amount of evidence of irrationality and repeated errors of judgement.
A field of behavioural finance has evolved that attempts to better understand and explain how emotions influence investors and their decision-making process. Daniel Kahneman, Amos Tversky, Hersh Shefrin, Meir Statman, Robert Shiller and Andrei Shleifer are among the leading researchers who have used theories of psychology to shine some light on the accuracy of financial markets, and explain stock market bubbles and crashes.
People frequently behave irrationally
One of the most basic assumptions that accepted finance makes is that people are rational. According to conventional finance, emotions and other factors do not influence people when it comes to making financial choices.
But the fact is, people frequently behave irrationally. For example, consider how many people purchase lottery tickets in the hope of hitting the 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 buy tickets week in, week out.
Despite strong evidence that the stock market is highly efficient, there have been scores of studies that have documented long-term historical anomalies (irregularities) in the stock market that seem to go against the efficient market hypothesis. While the existence of irregularities is generally well accepted, the question of whether you can use them to earn impressive returns in the future is subject to debate. Let’s now look at an example of one such anomaly; the winners curse.
End of excerpt
As always, if you have any questions or thoughts on the points covered in this post, please leave a comment below or connect with us @ISACO_ on Twitter.
ISACO specialises in ISA and SIPP Investment and is the pioneer of ‘Shadow Investment’; an easy way to grow your ISA and SIPP at low cost. Together with our clients, we have an estimated £57 million actively invested in ISAs and pensions*. Clients like us because we have a great track record of ‘beating’ the FTSE 100**. Over the last 16 years, we’ve outperformed the Footsie by 60.2% and over the last 5 years, we’ve averaged 14.5% each year versus the FTSE 100’s 8.8%. You can find us at www.ISACO.co.uk.
What is Shadow Investment?
Picking the right fund for your ISA and SIPP is not exactly the easiest job in the world. And knowing 'when' to buy and 'when' to exit is even more difficult! Our ‘Shadow Investment’ Service is here to help. Our service allows you to look over our shoulder and buy the same funds that we are buying.
When we are thinking of buying a fund, we alert you so that you have the opportunity to buy it on the same day that we buy it. We also tell you about when we are planning to exit the fund. You control your investment account, not us. You can start small and invest as little or as much money as you like.
By knowing what we are buying, when we are buying and when we are exiting, throughout the year you can mirror our movements and in effect replicate our trades. This means you have the opportunity to benefit from exactly the same investment returns that we get. Our investment aims are 10–12% per year.
We are totally independent, fully transparent and FCA compliant. We’re warm, friendly and highly responsive and it’s a very personal service that gives you direct access to the Sutherland brothers; ISACO’s two founders.
Who are ISACO’s clients?
Clients who benefit most from our service have over £250,000 actively invested and the majority of them are wealthy retirees, business owners, self-employed professionals and corporate executives. We also have clients from the financial services sector, such as IFAs and wealth managers.
Do you have questions?
To have all your questions answered, call 0800 170 7750 or email us at: info@ISACO.co.uk.
*November 15th 2012: Internal estimation of total ISA and pension assets owned by ISACO Investment Team and ISACO premium clients.
**Long-term performance: December 31st 1997 - December 31st 2013 ISACO 91.3%, FTSE 100 31.1%. 5 year performance: December 31st 2008 - December 31st 2013. ISACO Investment performance verified by Independent Executives Ltd.