The basics of behavioural finance [video]

And how to control your natural biases as an investor

    Exploring the economic impact of behavioural biases

    The irrationality of investors is predictable and expensive.  The best defence against our natural biases, for the majority of us, is a passive portfolio!

    You need to be aware of your biases

    Robin Powell: Hello there. There are all sorts of factors that impact on the returns investors receive, but perhaps the most important is the human factor. The problem is that, although markets are generally quite efficient, investors typically act in an irrational manner.

    Tim Richards is the author of The Psy-Fi Blog and an expert in how investors behave.

    Tim Richards: The way that they behave, particularly in the presence of money, isn’t what anybody would expect, it’s irrational because, in essence, people behave in ways which means that they lose money. And you can predict that they will lose money because of the way that they’re actually behaving.

    RP: Why is it important for investors to have at least basic grasp of behavioural finance? The answer’s simple. Bad behaviour is extremely expensive.

    TR: Some studies have shown three to four percent a year is being dropped by investors, purely because of making poor buying and selling decisions. Now that’s just one bias, that’s just one type of issue that they’re facing. So, if people are consistently making mistakes in terms of when they buy and when they sell stocks, over a lifetime that’s thousands, hundreds of thousands, millions of pounds, and you scale that up across the industry, it’s billions of pounds a year.

    RP: So, investors need to be aware of the different behavioural biases that exist. They also need to realise that they themselves are prone to them.

    TR: Actually there’s a fundamental issue called the blind spot bias, which means, although people will acknowledge that biases apply to other people, they find it very difficult to see that it applies to them, so you know, “Yeah yeah yeah, so and so has confirmation bias I can see it”, but actually not recognising that they themselves are suffering from the same problem.

    RP: For Tim Richards, the best defence against behavioural bias is a passive investment strategy — buying a very broad range of assets and holding them for the long term.

    TR: There’s absolutely a subset of people who should never be allowed near any kind of active trading account, ever. In between, in the middle, I think there’s a vast swathe of people who probably shouldn’t invest actively. And then I think at the extreme end there are people with certain psychological traits, particularly people who are able to isolate themselves from emotions, who can be effective active investors. Whether or not it’s worth putting the effort into making what might be a relatively small return at the end of it, is, it’s a moot point, some people might say yes, some people might say no.

    RP: Of course, passive investors are not immune to acting irrationally. For instance, you need to resist the temptation to bale out when markets are falling sharply.

    But recognising your biases, and having an adviser who understands them too, gives you a big advantage.

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