23 Jan Behavioural Finance – What’s your favourite bias?
What’s Behavioural Finance?
If you haven’t come across the term “behavioural finance” before, then it’s something I’d suggest that every investor gains at least a working knowledge of. In a nutshell, behavioural finance is the study of the effect of psychological traits on investor behaviour, countering the assumption inherent with traditional financial theory, that markets and investors behave perfectly rationally.
Why is it relevant to me?
If you owned a car which persistently steered to the left and stalled on hills, you would probably want to:
1) be aware of these potentially damaging tendencies, and
2) be ready to take evasive action by anticipating the behaviour.
In the “journey” of investing, our mental biases are comparable to such mechanical flaws, and may cause you to end up in a metaphorical financial ditch, if left to their own devices.
Let’s look at a few of my favourite biases in the “behavioural finance” space.
1) Loss Aversion: being so fearful of making losses, that your investing focus is predominantly on the avoidance of these, rather than on making gains.
- Impact: this may result, for example, in not selling out of a losing investment (so as to realise a loss) when your expectation is that it will continue to fall.
- Mitigation: utilise some of the traditional strategies available to lower the volatility/risk of your investment (e.g. hedging, investing in multiple asset classes, employing diversification).
2) Anchoring: defining a sense of value for an item based on the first information found, this becoming the “anchor” which has an undue influence over any subsequent data.
- Impact: seeing a stock in ABC.com trade at $100 on Monday and then $120 on Tuesday, an investor may choose not to invest on the second day, placing too much store on the original price and feeling that they have, therefore, “missed out” already (only to genuinely miss out when it goes to $150).
- Mitigation: rigorous, critical thinking: determine the actual intrinsic value of any item to determine if it is worth buying at a particular moment in time.
3) Framing: the tendency to come to a decision based on how the information was presented rather than simply based on the facts.
- Impact: being presented with an investment option which is “unique”, “limited time”, “only for the discerning few” etc may positively influence an investor to participate, regardless of the facts associated with the investment (which may well be in smaller print!).
- Mitigation: recognise the framing; statements of opinion, judgements, assumptions etc which may be encouraging an irrational response.
In summary, the most common, and powerful way to avoid the effects of these cognitive biases in finance is simply to be aware that they exist.
When considering an investment, literally ask yourself: “Which bias might I be suffering from here?”, and, having identified it, act accordingly to mitigate the risk.
Better still, speak to your financial adviser, who should be adept at recognising and avoiding such biases. Remember: don’t just follow the herd (yes, that’s another bias!).
Article by: Michael Davidson, International Financial Advisor at GFC – Global Financial Consultants Pte Ltd