An introduction to behavioural finance

We would all like to think that we are rational human beings that make sensible and logical decisions. Sadly, this is far from the truth and in reality we often make decisions fraught with biases, many of which we aren’t even aware of.

This is where behavioural economics comes in, the study of behavioural biases that can impact our decisions. A subset of this study is called behavioural finance, which specifically looks at biases that impact investment decisions. This is a huge and growing topic, so this post aims to introduce the concept gently. As part of this intro post we also had a chat with Dr Greg Davies, head of behavioural science at Oxford Risk, and we have shared some of his views and advice as part of this article.

"Individuals who cannot master their emotions are ill-suited to profit from the investment process."

Benjamin Graham, British-born American economist widely known as "the father of value investing"

What is behavioural finance?

Behavioural finance is a cross between behavioural psychology and finance theory. For many years, economic theory was focused on the assumption that people are rational all the time. Over the years, psychologists have pointed out that economists’ idea of “rational” is extremely narrow and doesn’t necessarily match with how people actually behave. Behavioural finance is an attempt to study how people make financial decisions in practice rather than assuming how they should, and to narrow the gap between the two.

Why has it gathered pace in the asset management industry (and beyond) in recent years?

There are a few reasons for this. One is because it started to make its way out of academia. People started to write popular books on these topics, Nobel prizes were awarded for them, so people started to pay more attention. That’s partly because it seems like common sense but also has some scientific grounding to it. It makes sense to people and it is also about people, and people like understanding themselves. But more than that, there is a sense that if we can use psychology systematically to improve our decisions then we will function better in various areas. There is a sense that it is a real toolkit that can be used for practical good.

When it comes to the asset management industry, the financial crisis ten years ago really focused people’s minds that the classical economic models weren’t working. Furthermore, if you based your investment decisions on the old traditional economic models you were missing a large chunk of what it means to make good decisions. Most recently, we have started to cross these ideas with technology and data analysis. That helps us to take these interesting, but perhaps rather fluffy, ideas and enables us to build decision support tools that are scalable.

What are the most common behavioural biases investors should be aware of?

Three general rules of investing are to get invested, diversify and generally not fiddle around too much, each of which is prone to a number of behavioural biases and barriers. First, time-preference bias. To get invested you have to look beyond the present in order to see the longer-term benefits of investing. An example would be the hurdle of moving savings from what is often thought of as a safe place, like a bank account to an investment account, which feels inherently riskier and where the reward is likely to be many years down the line. This is the reason many of us tend to shy away from making any financial decisions at all or decide to leave it until the next year. The next year we do the same, and 20 years down the line we turn back and think “I wish I had saved more 20 years ago”.

Second, familiarity bias. Diversification means to invest in a basket of different things, some of which will be more familiar than others. We feel comfortable buying things we are familiar with and in investing that often takes the form of having more money invested in the country you live in than any other region, or investing more in industries that are aligned with personal interests and products you may use in your daily life. There are several problems with that, including overconfidence. Just because you know the country or the product a company produces, doesn’t mean it is necessarily a good investment.

Third, action bias. Investing is a long-term game that requires time for the miracle of compounding to have an impact. The problem with humans is that we generally consider inaction to be bad, or worse - a sign of laziness. Particularly during times of stress, we don’t like to feel that we are doing nothing (even if inaction may in fact be the best course of action). So, we like to do things to prove, even if only to ourselves, that we are decisive, in control and know what we are doing. For a professional investor this can be summed up as: earning our keep.

In the case of investing this takes the form of trading. We can feel compelled to trade because it might seem irresponsible to let our investments sit on the shelf collecting dust, or sometimes we just get bored of doing nothing. However, it is often best to have a few simple long-term asset allocation goals, make a few informed decisions and then leave it alone, only rebalancing if the asset allocation has gone significantly off course.

There are a whole host of other biases of course that influence our decisions (investment and other), but these are some of the main ones.

How can biases be overcome?

Awareness and preparation are two of the best remedies. Knowing and acknowledging that biases exist and can influence our decision making is a good start. The next step is trying to identify which biases you are prone to most. Everyone isn’t prone to the same biases, but nobody is free from biases. Some of us are more susceptible to familiarity bias, some of us tend to get anxious when markets get volatile and therefore more susceptible to action bias. A good tip is to keep an investment journal tracking your decisions over time, when you did something, what you did, and why. This doesn’t have to mean that you need to keep a detailed diary on your nightstand. Many of us make half a dozen, or fewer, investment decisions a year and jotting down a quick couple of sentences each time should take you less time per year than watching one episode of your favourite Netflix series. Not a huge effort one could argue, but one that might be worth making if it can help you make better investment decisions in the future. Besides, keeping an investment journal is a bit of a thing amongst professional investors, and who doesn’t like tips from the pros?

Once you have overcome the first hurdle of awareness of your biases, you can start preparing for how to manage them. This takes some focus and dedication in order to build useful habits. It’s a bit like trying to build a habit for exercise, it can be tough in the beginning, your instinct tells you to do something else and it generally takes a while before it feels less like work and more like second nature. Once you know what your biases are, it is easier to identify which situations they are most likely to impact your decisions. You can then create some rules, perhaps even just questions to ask yourself before making a decision, to make sure you are actively considering the biases in your decision making. It might sound like common sense but that is the whole point, it’s obvious in theory but tricky in practice. It is a bit like mindfulness in investing, no yoga mat required.

How does a crisis, like the COVID-19 one, affect decision making?

The big concern is the pervasive effect of anxiety, particularly when a crisis is prolonged and so multi-faceted like the COVID-19 one. One of the things that protects us from turning sensible reactions into knee jerk, panic-driven, actions is what we might think of as our reservoir of emotional liquidity. Like financial liquidity, it is also constantly being chipped away. Sooner or later, people become prone to impulsive and emotionally driven decisions despite their best efforts, and this is the most important thing to guard against. It’s not even just about investing behaviour, it’s about general mental wellbeing and resilience. In this current crisis, these things are tied together in a way they never have been before.

Books and podcasts recommendations for anyone who wants to find out more about behavioural finance

Books:

The Little Book of Behavioural Investing by James Montier

Thinking, Fast and Slow by Daniel Kahneman’s

Fooled by Randomness and Antifragile by Nassim Taleb

Nudge by Richard Thaler and Cass Sunstein

Podcast:

The Human side of Money by Brendan Frazier

Date of publication: 25th November 2020