How behavioural finance can help improve investment returns

Do you know somebody who suffers from hindsight bias As I’ve mentioned in three previous blog posts, 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 behaviour, 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 four in the series.

The good news is that we are currently offering the paperback version of How to Make Money in ISAs and SIPPs (RRP £9.95) and a paperback copy of my bestselling classic, Liquid Millionaire (RRP £19.95) – for just £4.95! But this offer is only available to the first 100 people that respond. Buy now to avoid disappointment.

Excerpt below taken from Chapter 9, How to Make Money in ISAs and SIPPs

Hindsight bias

Many events seem obvious in hindsight. Hindsight bias tends to occur in situations where a person believes (after the fact) that the beginning of some past event was predictable and completely obvious, whereas in fact, the event could not have been reasonably predicted. Psychologists connect hindsight bias to our inborn need to find order in the world by creating explanations that allow us to believe that events are predictable.

For example, many people now claim that signs of the technology bubble of the late 1990s and early 2000s (or any bubble in history, such as the Tulip bubble in the 1630s or the South Sea bubble of 1711) were obvious. This is a clear example of hindsight bias: if the creation of a bubble had been obvious at the time, it probably wouldn't have escalated and eventually burst.

Blame the adviser

Another example of hindsight bias is when an investor blames their adviser for choosing the worst performing fund in their portfolio. The investor suffering from hindsight bias will say things to their adviser like, ‘Why did you recommend this underperforming fund?’

What the investor is unfortunately forgetting is that in a portfolio there are always going to be winners and there are always going to be losers. The investor is failing to look at the bigger picture of the ‘total performance’ of their portfolio and see that it wasn’t so obvious that the fund in question was going to turn out to be a poor performer.

Herd behaviour

One of the most shocking financial events in recent memory was the bursting of the internet bubble. However, this wasn’t the first time that something like this had happened in the markets. But how could something so harmful be allowed to happen over and over again? The answer to this question can be found in what some people believe to be a hardwired human quality: herd behaviour, which is the tendency for individuals to copy the actions (rational or irrational) of a larger group.

Individually, however, most people would not necessarily make the same choice. While it's tempting to follow the newest investment trends, you are generally better off steering clear of the herd. Just because everyone is jumping on a certain investment bandwagon it doesn't necessarily mean that the strategy is correct.

Overconfidence

Another decision-making bias that humans are prone to is overconfidence (i.e. overestimating your ability to successfully perform a particular task). Psychological studies show that, although people differ in their levels of overconfidence, almost everyone displays it to some extent. For example, way more than half the population claim to be above average drivers, or have an above average sense of humour.

There is also an inclination for individuals to place too much confidence in their own investment decisions, beliefs and opinions. Lack of confidence is paralyzing, self-confidence is good, but overconfidence is deadly. Overconfidence can cause real problems for investors who mistake luck for skill. For instance, when something turns out well after a decision we’ve made, we claim the credit.

However, when something goes badly, we tend to see this as just bad luck. Many investors fall into the trap of believing that they can pick winning investments. As a result, they sometimes put too much of their wealth into one single investment, such as a company stock, which can be very risky. Research shows that picking winning investments is incredibly hard to do, even for professional investors.

Investors with too much confidence in their skills often buy and sell too frequently, which can have a negative effect on their returns. Overconfidence manifests itself when we think we can out-guess the market in terms of short-term movements, resulting in us trading actively, trying to capture each mini-peak-and-trough. Unfortunately, that usually just leaves active traders poorer.

End of excerpt

I hope you liked the excerpt and thank you for reading it. Remember, we are currently offering the paperback version of How to Make Money in ISAs and SIPPs (RRP £9.95) and a paperback copy of Liquid Millionaire(RRP £19.95) – for just £4.95! This offer is only available to the first 100 people that respond.

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.

About ISACO

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.

* Kahneman and Riepe, 1998.
**November 15^th 2012: Internal estimation of total ISA and pension assets owned by ISACO Investment Team and ISACO premium clients.
***Long-term performance: December 31^st 1997 - December 31^st 2013 ISACO 91.3%, FTSE 100 31.1%. 5 year performance: December 31^st 2008 - December 31^st 2013. ISACO Investment performance verified by Independent Executives Ltd.