Learning from behavioural finance
Expected returns versus actual returns Portfolios are built on what are believed to be carefully thought out and well-researched ideas. However, investment performance often falls short of expectation and investors are disappointed with the actual returns achieved. Is this because we invest too little too late? Have we become too attached to individual stocks? Are our portfolios not diversified enough? This gap between expectation and reality is not limited to a few individuals who may perhaps be inexperienced or fall prey to faulty information but is often widespread. This is demonstrated by the formation of ‘bubbles’ in the market – most famously in recent times in the technology sector on the back of the rise of the dot com. Investors both amateur and professional were affected by the subsequent drop – no-one is immune from less than objective decision-making.
Strengthening the decision-making framework Behavioural finance seeks to address these anomalies by identifying the cognitive and emotional biases which should be avoided in order to build a robust portfolio which is protected from investment whims or fads. Researchers in this field have found that, bombarded continuously with news information, investors often rely on heuristics to manage information overload and to help solve complex problems. These ‘rules of thumb’ or ‘cognitive biases’ are commonplace. However, by recognising and addressing them, they are correctable. A typical example is:
- Overconfidence: Placing too much emphasis on one’s own abilities and hearing only what you want to hear. This is one of the most problematic biases for investors. For example, when traders moved from trading over the telephone to the internet1 they found they could increase the volume of their trades significantly and implement more ideas. The result – a significant downturn in performance.
Other behavioural biases have their roots in impulsive feelings or intuition rather than cognitive process – these are ‘emotional biases’ and are more difficult to correct. A typical example is:
- Risk Aversion: In general people are risk averse and are nervous at the prospect of losing money. Individual investors are 50 per cent more likely to sell a winning investment than a losing investment (Odean, 1999). In addition, continuing to hold the losing stock fosters the belief that the original investment decision was a good one.
Tackling the problems As individuals increasingly assume more responsibility for their own financial security, any obstacle that hampers making prudent financial decisions is significant. Behavioural finance may help by redirecting the focus from isolated events to the bigger picture. Some practical approaches suggested by behavioural finance for tackling these biases include:
- Strengthening governance: Making sure there are sensible due diligence processes in place which can ensure that we take into account all appropriate information when making decisions.
- Focus on the risk budget: Undertake a thorough risk analysis to ensure you are minimising unrewarded risk.
- Performance: Avoid having ‘favourites’ and ensure that there are reasons for holding underperforming stocks or funds – such as defensive stocks in case of a market downturn otherwise sell them before you lose more money.
In conclusion, our key takeaway from behavioural finance should be to recognise that past performance is not an effective guide to the future... and usually isn’t even an effective guide to the past. We need to balance overconfidence against risk aversion, ensure that we continue to question pet theories and practices and embrace new ideas. 1 Barber, B., and T. Odean (2000), “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” Journal of Finance, vol. 55.
