Economic theory in today’s day and age is extremely powerful and can be applied in the real world to create effective investment strategies tailored to investor goals.
However, overshadowing every technical investment theory is the concept of “behavioural finance”, used to explain why humans can (and so often do) make poor financial decisions even in light of the effective theoretical tools we have at our disposal.
We explain a few key concepts around behavioural finance to avoid traps and help you make healthy investments.
First there’s the concept of “heuristic techniques”.
This sounds complicated, but all this means is that as humans, we like to simplify things to make decisions quicker and easier. Rules of thumb, educated guesses, intuitive judgment, stereotyping and trial and error are all examples of heuristic techniques that may give us what we need in straight-forward scenarios. However, in complex or layered issues, sometimes using heuristic techniques means we don’t consider all the variables in a problem. So while heuristic techniques may work in certain scenarios, they are not ideal in the investment environment, often leading to “cognitive biases” – also known as failing to use logic, probability or rational choice in decision-making.
In addition to cognitive biases, investment decisions can also be impacted by emotional biases.
Which are born from social and life experiences leading us to act on feelings rather than facts. There are a number of different sub-categories of emotional bias, some of which are summarised below:
- Herd Behaviour: the tendency to follow the pack and follow the populace when making investment decisions because it feels like a safer approach.
- Overreaction: the emotional response to news about an asset driven by fear or greed that can over inflate or under inflate the price of an asset above or below its fair value.
- Confirmation bias: the tendency to research information that supports your initial perspective or opinion and omit information that might counter or challenge your views.
Each of these examples of emotional bias can play a part in the investment realm and can lead to poor investment decisions being made. Behavioural finance connects the ideals of investment theory to the real world, explains what can lead to us ignoring theoretical concepts and in doing so allows us to factor this into our investment decision-making.
If all investors made rational decisions and markets were efficient, the world wouldn’t suffer from economic bubbles and crashes such as the Global Financial Crisis in 2008. Providing a basic introduction to behavioural finance will help you avoid investing without keeping technical ration and logic at the forefront of your mind.
If you would like us to check your investment strategies and how your behaviour may be impeding your investment success, please get in touch!