YOUR emotions can be your own worst enemy when it comes to managing money.
They can cloud your thinking, skew investment decisions and foster an inappropriate appetite for risk.
Behavioural finance, or the study in how emotional, social and cognitive factors impact financial decisions, should therefore be a key weapon in an investor’s armoury.
Behavioural finance suggests we overweight our personal, recent experience when arriving at judgements.
We also tend to extrapolate from current circumstances into the future. Not only are we prone to overconfidence, we also seek out confirming evidence for our views.
An ability to respond quickly to perceived danger was a successful strategy in our evolution, but as an investment strategy fear is self-defeating. It leads to overreaction to irrelevant information and induces investors who bought at the top of the market to sell at the bottom.
The best investors seem not to have inherited these debilitating psychological traits. They are patient, operate with long-time horizons and are prepared to leave the herd and tolerate periods of underperformance.
Apart from the more obvious basic emotions of fear and greed that can stalk an investor, behavioural finance highlights a number of more complex emotions that can come into play.
For example, all investors can suffer from overconfidence in their own abilities. The good investments are put down to skill while the poor investments are just bad luck.
Behavioural finance also teaches us that investors are prone to a phenomenon known as confirmatory bias.
They have a tendency to seek positive reinforcement for the views they already hold. They look for arguments that reassure them their decision was right to invest and don’t focus on any counter argument.
Therefore, investors should consider counter arguments that challenge their core views. Here raw numbers can help as they are much more subjective.
It’s the ultimate check on whether investors are being too confident and not considering potential difficulties ahead. For example, comparing market price earnings ratios against their long-run averages are often a good indicator of markets being cheap or expensive.
In fact, the impact of behavioural biases can be felt everywhere, not least in the role they may have played in the financial crisis of 2008. In the run up to the crisis investors put too much emphasis on their recent experience.
It could be argued that one of the biases up until the crash revolved around the idea that lending money to individuals secured against the value of their house was a failsafe investment strategy. After all, house prices, so it went, had never gone down in the US.
Yet they did fall as the crisis took hold. What we see here is a bias around the perception there are some assets that will never disappoint but when they do there are enormous problems. The same may be true today with the perception that central banks will undertake further quantitative easing if markets take a downturn.
For individual investors, one of the most obvious behavioural biases is loss aversion. In a world of smartphones and instant internet connections, more and more people track the movement of their investments on an hour by hour, day by day basis.
Yet, as behavioural finance experts will tell you, the more you look at any investment, the more likely you are to see it falling in price. Investors can also fall into the trap of tracking their investments too closely and reacting inappropriately.
It would be impossible for people to protect themselves from all the emotional, social and cognitive factors that assail them every day.
However, armed with an awareness of their influences on their financial thinking they will be in a stronger position to prevent these biases from taking hold.
As Warren Buffet, the billionaire US investor, famously commented it pays to “be greedy when others are fearful and fearful when others are greedy”.
David Thomson is chief investment officer at VWM Wealth.
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