How to Use Behavioural Finance to Become a Better Investor

*This post “How to use Behavioural Finance to Become a Better Investor” may contain affiliate links. This means if you purchase through the link I will receive a small commission at no cost to you. It is the way sites like this are funded, but does introduce a conflict of interest.  

Definition

“Behavioral finance attempts to explain and increase understanding of the reasoning patterns of investors,including the emotional processes involved and thedegree to which they influence the decision-making process.”

Ricciardi, Victor & Simon, Helen. (2000). What Is Behavioral Finance?. Business, Education & Technology Journal. 2. 1-9.

I am fascinated in research around human behaviour with money and investing. Over and over we hear the same cardinal rules about finance and investing:

  • Spend less than you earn
  • Regularly and consistently invest over several decades
  • Investing in low cost passive index funds is the easiest, cheapest way to grow wealth
  • Minimize fees including brokerage, management fees etc
  • Buy assets that grow in value or provide income rather than those that produce costs (particularly at the start of your journey)
  • Ignore the noise and just stick to your written investment plan

It’s not rocket science! Over the last decades the introduction of superannuation, cheap online brokers, and micro-investment apps have made investing attainable for everyone. It has never been easier to take the simple steps to secure a strong financial future.

So why do most investors struggle to stick to the script?

During the 1990-2000s, Behavioral Finance attempted to answer these questions.

Behavioural Finance: Why do We Struggle to Spend Less than We Earn?

Clever marketing surrounds us almost constantly. Most of us like to believe we are immune to advertising. But extensive human psychology research, aimed at manipulating the audience subconsciously, informs the design of these advertisements.

  • Colour – the background of an advert or show room is purposely chosen for a particularly subconscious association. This is proven to impact consumer behaviour
  • Subliminal messaging – hidden messages within adverts and other media
  • Emotional branding – manipulating consumer emotions to create a loyal customer
  • Autonomous sensory meridioal response technology – Do you experience a shiver or tingle with certain sounds? Brands intentionally create these pleasurable auditory sensations to engage you with online platforms or make consumers more likely to like the product advertised
  • Creating artificial scarcity – Consumers desire brand name product of which there are few available, which is why brands create demand through artificial scarcity.

We are probably far more affected than we ever realize.

Humans also have a natural tendency to prioritize the short term over the long term, so have a natural resistance to delayed gratification. And we are constantly surrounded by messaging encouraging the answer to our problems is a new product.

It’s no surprise so many fail to get past the first step – Spending less than you earn.

The Efficient Market Hypothesis.

The efficient market hypothesis of the 1970s assumed that all market participants are rational and self-interested, and aiming to maximize returns.

The theory suggests all available information is priced into the market already, making it impossible to “beat the market” unless you have inside information (which is illegal) or take additional risk (eg leverage).

It is clear that the stock market as a whole is not entirely rational. There have been many speculative bubbles. Price appreciation has resulted in irrational over-enthusiasm, and further price appreciation until eventually rationality kicked in, and the bubble burst.

Lots of speculators made a fortune during the tulip mania of the 1600s, and the dot com boom of the 2000s. Late adopters (or those that didn’t get out in time) were often wiped out when prices eventually crashed.

Warren Buffet is the most famous investor in the world. He is one of a handful of investors in history to have consistently taken advantage of stock market irrationality to make above-average returns.

Thousands of professional fund managers try to replicate this market arbitrage with a dismal success rate. It turns out, although the market can be very irrational, investors (even professionals) are the cause of that irrationality.

Unless you as an investor are less irrational than the rest of the market, the efficient market hypothesis may as well be true.

Below is an infographic from SPIVA demonstrating the underperformance of funds vs the ASX 200 over 15 years. Active funds actually outperformed the Australian index in 57.76% of cases over the past year, the most positive timeframe.

SPIVA | S&P Dow Jones Indices (spglobal.com)

What chance as the average hobbyist investor got?

“People systemically depart from optimal judgment and decision making”

Barber and Odean

WHY DON’T WE CONSISTENTLY INVEST OVER THE LONG TERM ACCORDING TO THE PLAN?

The need to invest regularly, no matter what the market is doing is widely advertised. Missing a few days of market returns by sitting on the sidelines awaiting a market correction can result in dramatic damage to overall returns.

Yet market timing is a huge temptation to most investors. It seems so easy to improve returns by just timing those investments a little better. The data tells us it is unsuccessful most of the time. But many investors can’t help but think they can beat the odds. Why is that?

Prospect theory/loss aversion/Regret Theory– Are all based on the fact we hate to lose money and will adjust decisions based on the anticipation of regret.

In fact, we hate losing $100 far more than we love to win $100. This skews our risk assessment. For many, this results in failure to invest at all, due to the fear of the market going down.

Excellent explanation of loss aversion by Quikeconomics

It also explains why investors are so tempted to remove their money from the market when a crash seems imminent. Unfortunately, massive market losses are predicted almost constantly, and the market is rarely predictable.

As a result, investors who divest for fear of a market crash are at a real risk of missing out on the best days in the market.

Delaying investing because of bad market predictions for fear of loss and regret is another example of how you are likely to lose profits by trying to avoid risk.

Anchoring Bias

Holding on to a poorly performing asset (eg poorly picked property investment or individual shares) despite all indications this is a long-term underperformer is also common. Investors cannot stand the pain of selling for a loss. They often demonstrate anchoring bias, waiting for the price to return to what they paid (No matter how long that takes). It’s the tendency for the first price to become anchored in our brains.

Investors struggle to overlook the anchoring to see the opportunity cost of having money tied up in a dud investment – that cash could actually be making money elsewhere.

Fascinating experiments on Anchoring bias – Quik Economics

Hindsight bias

Ever heard someone exclaim they knew something was going to happen, when in fact you know they did not make a strong prediction?

They’re not just lying, you probably do it too. Our brains play a trick on us when new information becomes available, in updating memories, often to include the new information.

When investing results appear predictable due to hindsight bias, it is easy to become overconfident in your ability to predict the future.

WHY CAN’T WE JUST STICK TO DIVERSIFIED PASSIVE INVESTING?

For most of us plain old vanilla investing has the best chance of getting us to our goals. But there is an ever-lasting temptation to try and beat the average with a more complicated plan.

The property next door goes up for sale. You know the neighbourhood inside out. It’s a comfortable investment. You may skimp on the research due to familiarity bias, a tendency to favour assets we feel familiar with. Although you might like your neighbourhood, this house is not necessarily the best choice for your portfolio. The decision should be just as rigorously researched as any other investment decision.

When researching an investment decision (and most other decisions), we are prone to confirmation bias, the tendency to screen out any evidence contradicting our desired action and only taking notice of information that supports our case.

Why Don’t We Ruthlessly Minimise fees?

Investors have a terrible habit of flip-flopping inside their portfolio, wasting returns away in brokerage costs as they are chasing the latest must-have stock. It is well documented that lower trading results in higher performance. Much like switching lanes in heavy traffic, it’s unlikely to get you anywhere fast.

Overconfidence is a huge risk to your investing returns. Most of us tend to think we are better than average, obviously, that is impossible! So when we look at the dismal results of the average investor compared with the index and assume we will do better, most of us are deluding ourselves. Those with high skills in other areas tend to assume they will also be better than average in finance, but the skills often do not transfer.

And then to compound this problem is the issue of self-attribution bias. When an investment choice goes well, we tend to take the credit and assume the success was due to our intellectual decision-making. When there is a poor result, some other sucker tends to get the blame!

WHY DON’T WE JUST STICK TO THE PLAN?

Humans exhibit herd behaviour. It’s uncomfortable to go against the crowd.

If there are two restaurants next to each other, and restaurant A has a line up outside and restaurant B is empty we tend to assume all the people wanting to go to restaurant A know something we don’t and assume it must be better. Savvy restauranteurs offer free drinks on quiet nights to get the crowd started.

The fear of missing out is a powerful emotion. Reading about investors becoming millionaires investing Bitcoin certainly made me stop and wonder if I was doing it all wrong. It sounds so easy! And fast! I even downloaded a podcast to learn more about this. Alas, I am not convinced I can understand the case for bitcoin beyond the fact the technology has great potential, although we’re not exactly what for yet. Teaching is a great exposer of understanding. If you can’t explain something simple enough for anyone to understand I’m not convinced you understand the concepts well enough yourself.

“Don’t invest in something you don’t understand.”

Warren Buffett

Behavioural Finance Behaviour Modifications

Being aware of these biases we are all prone to is the first step in limiting their damage. The second is to build a system of behaviours that help counteract bias. Some suggestions include:

  • Direct debit your savings out automatically each pay so you have no choice but to spend less than you earn
  • Have a written investment plan that you refer back to when considering changes.
  • Have a time delay (2 weeks? A month?) before making the changes to your investment plan. Document why you changed and your new investment plan
  • Have a plan for when you are feeling nervous about market corrections (not to log into your account until you hear media reports of recovery, JLCollins stock market meditation)
J.L. Collins Stock Market Meditation!
  • Research investments thoroughly but set a time limit by which you need to take action. Accept there will always be some risk, you can only minimize it.
  • Have an investing advisor or knowledgable buddy who you can discuss your decisions with. They will be able to identify hindsight bias, familiarity and confront your confirmation bias
  • Read/listen to many sources of information, including some that don’t follow your investing philosophy. Challenge your assumptions and learn to understand the the point of view
  • Assume you are an average investor. Be realistic about your capabilities. Just because you’re an incredible neurosurgeon* (*insert own impressive profession) doesn’t mean you are also Warren Buffett.
  • Keep an investing journal. Look back to see if you really “saw it coming”.

Behavioural Investing Conclusion

“It is possible that an investors’ biggest problems and their most dangerous enemy is himself.”

Benjamin Graham.

Although traditional economists believe in the idea of rationality in individuals, financial models are oversimplified.

Emotional and cognitive biases heavily influence investor behaviour. The resulting irrational behaviours can cause huge losses.

Only by recognizing behavioral biases in our lives can an individual investor make logical decisions. Behavior-based financial research provides fascinating insights into real financial behavior.

Further Resources for Behavioural Finance Geeks:

From Efficient Markets Theory to Behavioral Finance (aeaweb.org)

Quik Economics youtube channel

Aussie Doc Freedom is not a financial adviser and does not offer any advice.  Information on this website is purely a description of my experiences and learning.  Please check with your independent financial adviser or accountant before making any changes.

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