Irrational investment decisions occur more often than one might think.
Investors let fear, greed, recent experience, and hubris impact their financial decisions. These emotions can be categorized into different behavioural biases and impact more than just investment decisions - they are present in our everyday life. Take for example this simple statement: “it was the best vacation ever”. Is the recent experience blocking out previous vacations? Might a person be trying to justify a sunk cost? Or perhaps it really was the best vacation ever! Regardless, the statement is fraught with behavioural bias.
Successful investing is just as much an art as it is a science, which means each investment decision needs to be carefully considered with the understanding that our intuition is impacted by our emotions. While objectively reviewing our decisions can help improve our choices, we may find the outcome difficult as it challenges preconceived ideas.
The study of these biases and emotions, in the context of investing, is called behavioural finance. This is where psychology is used to analyze the financial decision-making process of humans. Simply put, behavioural finance is the study of how emotions contribute to the decisions people make about money. Insight into this field of study helps investors recognize the behaviours that lead to erroneous decisions resulting in less-than-optimal outcomes.
"Our comforting conviction that the world makes sense rests on a secure foundation: our almost unlimited ability to ignore our ignorance."
Daniel Kahneman, Thinking, Fast and Slow
Changing economic situations, political unknowns, and a relentless news cycle persuades investors into believing they need to make changes to be successful. Recognizing what we know and what we think we know isn’t easy. As Daniel Kahneman, a Nobel Prize winner who’s credited with showing the relationship between psychology and economics, suggests , people are nearly hardwired to believe they understand the correct course of action, while at the same time completely ignoring concepts that challenge their beliefs. Investment decisions are not exempt from this concept. Portfolio construction and investor behaviour are two sides of a successful investing coin. Success in one area will not be enough to make up for a failure in another; to achieve success requires a blend of disciplined portfolio construction and tempered investment behaviour.
Behavioural investing is the application of behavioural finance principals with the goal of improving investor behaviour. In part two of our series we will discuss relevant biases, and by bucketing these biases, we will draw attention to common themes. In part three we will identify practical strategies that may help improve your investment decision-making process.
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