The Big Win
Following on from Tor’s article last week, Mark shares his thoughts on the topic of behavioural finance with a focus on investor characteristics and psychology.
At the announcement of Professor Thaler’s award, it was stated that he “has incorporated psychologically realistic assumptions into analyses of economic decision-making. By exploring the consequences of limited rationality, social preferences and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes.” To the retail investor, behavioural finance remains one of the most destructive forces on an individual’s portfolio. Individual investors often fail to act rationally based on numerous influences in the market. Biases include:
- overconfidence – believing the market will just continue to rise or fall;
- hindsight – believing that past performance is indicative of future movements;
- familiarity – for example, working in the auto industry and diversifying or investing in that area alone; and
- unrealistic expectations – expecting, for example, a 10% return on a portfolio that has a large percentage of fixed income.
It’s an important statement from the Nobel Foundation to recognize yet another behavioural economist. Past winners include George Akerlof, Robert Fogel, Daniel Kahnemam, Elinor Ostrom and Robert Shiller. As David Booth stated, “The most important thing about an investment philosophy is that you have one you can stick with.” This statement helps beat back the behavioural biases that each of us are seemingly imbued with on a regular basis. What makes these biases so difficult to overcome is down to the fact that they are psychologically motivated. If it were, say, simply investing in a mathematical way, it would be easy. That’s what quantitative money managers do and it lends itself to a simple algorithm (that is, if algorithms are simple). A computer program is much easier to control than one’s own psyche.
One way to combat these psychological impediments is to endeavour to not listen to the talking heads on TV or the countless “financial” blogs, publications, magazines, etc. It’s not easy to keep at bay all the influencers out in the marketplace trying to tell you what you should be doing. However, most, if not all of these publications or programmes, are simply trying to sell something like air time on TV or ad space in a magazine. Think back to what David Booth said. Put a plan together and DON’T deviate. If you need funds from your investments, plan in advance. Otherwise, short-term market ups, downs and flat lines have little effect on your portfolio over the long-term.