The human brain really isn’t wired right to handle investing. Thanks to the ape-brains of our ancestors we don’t process data logically. Critical thinking is the antidote. But we don’t always realise that we’re not behaving logically.
The good news is that behavioral economists, neuroscientists and many others are studying the effect of psychology and emotions on our investing behaviour. Individual investors can benefit from their research.
I’ve put together a really basic explanation of some of the behavioural finance concepts that hold us back:
Anchoring. This is about tying decisions to anchors that may not be logical. The classic example in New Zealand in recent years were the benchmark apartment prices that dodgy dealers such as Blue Chip based their selling price on. These prices weren’t based on the prices apartments were changing hands for on the open market. They were based on other equally dodgy valuations. Investors believed the framework of these valuations and anchored their decisions on that.
Mental accounting. Humans don’t have the computing skills in their heads to tie individual decisions to their overall wealth. So they treat money from different sources in different ways. For example, humans treat “paper losses” and “realised losses” differently. Another example is that we view spending dividend income in a different way to dipping into capital.
Decision framing. We filter information to make it easier to deal with. When we frame decisions in this way we are taking a mental shortcut, but the results aren’t always logical. The classic one comes with KiwiSaver where people think they are conservative investors and use that frame to sign up for a conservative fund believing it will give them the best return. They’ve not employed critical thinking, such as, considering that the lower long term growth result sin them losing money in comparison to other KiwiSaver options. Instead they blank out what is outside of the frame.
Temporal discounting. Humans prefer rewards now – such as buying consumer goods – than rewards later. We “discount” the value of that later reward. We can’t see ourselves in the future. If we could – we’d make very different decisions.
Hindsight bias. Investing through the rear vision mirror is alive and well. Just look at all the people piling into gold at the moment – once the price has already gone stratospheric. Hindsight bias leads us to assume that we can predict the future. In this case, that gold will keep rising in price.
Herd behaviour. Once again the current gold rush is a classic example of behavioural finance – in this case herd behaviour. So was the need to buy investment properties in the past decade. We follow the herd because of social pressure for conformity and the belief that the group can’t be wrong. Investing with the herd is often unprofitable in the long run. The opposite is contrarian investing.
Prospect theory. People value gains and losses differently. They take bolder decisions to avoid losses than one made to achieve a gain.
Gamblers fallacy. This is where people think they can predict random events. They buy or sell investments based on that fallacy, such as continued holding of a fund or share because they don’t believe that probability allows for more falls.
Finally, academics do PhDs on these subjects and there is a wealth of information on the Internet for anyone who wants to expand their understanding.