Of all the decisions we make, investments ought to be the most rational. We should be able to whip off our rose-coloured glasses, replace them with green eyeshades and choose the lowest-cost investments with the highest-expected returns to create a diversified portfolio.
However, as with so many things in life, our emotions often get in the way of this rational approach. We buy shares in a company solely because a friend recommended it. Or, we innately believe the higher-priced product is always better, even though we have no evidence to back this gut feeling.
Those are just two examples of how our brains may mislead us when we ponder money. We're supposed to be rational, but more often than not, we are often irrational.
Understanding the general tenets of behavioural finance can help investors counter irrationality and improve investment decisions. It studies the psychology of financial decision-making and is based on a sub-field of behavioural economics. This field of research began when economists noticed that a pillar of economic thought known as the efficient market hypothesis often wobbled in the real world.
Its hypothesis posits that in a market with enough buyers and sellers, and where all investors have the same information, it's impossible to beat the market. But some investors do beat the market, often by capitalising on the irrationality of others. This caused economists to try to discover why.
And here's five key concepts from their findings:
Anchoring: This refers to the tendency to depend on, or get anchored in, limited information – some of it irrelevant to the matter at hand – to make decisions. Investors sometimes get anchored in certain numbers, which may influence whether we perceive a share price or market index to be high or low. A company share make look like a bargain if it falls from, say, $100 to $80, but the drop in price may not be relevant. The relevant question should centre on the company's expected return over a time horizon. And that is not an easy or straightforward answer.
Herd bias: Every time parents ask their children whether they would jump off a cliff if their friends did, they are actually referring to the concept of herd bias, the tendency to hop on a trend because “everyone else is doing it”. The dot-com boom and bust is one of many examples of the dangers of herd bias.
Home bias: The preference for sticking to the familiar has often resulted in investors investing in the shares of the country where they live even though diversifying internationally can generate stronger returns and lessen volatility. Home bias is especially prevalent in Australia. Australia accounts for just 2% of world markets, but figures show that Australians put 61% of their share investments in local companies. More research found the same effect affecting property investors, prompting them to invest in their own neighborhood, or close by, which may concentrate risk.
Attention bias: Advertisers count on attention bias. People are more likely to buy something they have heard of. So are investors. Research suggests that people are more likely to invest in companies they have casually read about or heard about on the news, for example.
Endowment bias: People tend to hold on to investments they already own, perhaps because they suffer from loss aversion. This bias has sometimes resulted in investors holding on to money-losing investments simply because it's painful to own up to a mistake.
Awareness of how our brains sometimes cause us to make poor choices can be the first step to making better ones.
Fortunately, there are shortcuts that can help you break these behaviors.
One simple solution is to adhere to four simple principles that will help improve the chances of a successful investment portfolio – goals, balance, cost and discipline. Set your goals, choose a number of well-diversified managed or exchange-traded funds with strong long-term track records. Keep your investment costs low. And finally, maintain long-term perspective and a disciplined approach to your investment strategy.
At the very least, you'll be less vulnerable to buying that share you just heard about on television.
Written by Robin Bowerman
Head of Corporate Affairs at Vanguard
18 October 2019