Behavioural finance is a discipline that attempts to explain and increase understanding regarding how the cognitive errors (mental mistakes) and emotions of investors influence the decision making process. It integrates the field of psychology, sociology, and other behavioural sciences to explain individual behaviour, to examine group behaviour, and to predict financial markets. According to behavioural finance people are not always rational: many investors fail to diversify trade too much, and seem to selling winners and holding losers. Not only that, but they deviate from rationality in predictable ways.
According to standard finance pricing model, people value wealth, the presumption is that investor act carefully and objectively while making financial decisions. Financial economists assumed that people behaved rationally, when making financial decisions. Researchers in psychology discovered that economic decisions are often made in a seemingly irrational manner. Over past decade, the field of behavioural finance has evolved to consider how personal and social psychology influence financial decisions and the behaviour of financial market.
Behavioural finance promises to make economic model better at explaining systematic investor decisions. Taking into consideration their emotions and cognitive errors and how these influence decision making. So behavioural finance is not a branch of standard finance; it is replacement offering a better model of investor psychological decision process.
Thus behavioural finance can be described in the following ways:
- Behavioural finance is the integration of classical economics and finance with
psychology and the decision making sciences.
- Behavioural finance is an attempt to explain what causes some of the anomalies that have been observed and reported in the finance literature.
- Behavioural finance is the study of how investors systematically make errors in judgment or ‘mental mistakes’.
For investors, it begins by establishing an on-going dialog with your advisor around three questions:
How much can we lose?
How repeatable is our process?
How educated am I?
- Understand the risk by asking, “How much can we lose?”
With every investment program that CWA and Tectonic recommends, we look at the risk of loss and stress test the portfolios for various scenarios that could unfold in the markets. This includes looking back over an investment manager’s history to see how they’ve handled periods of stress in the market. By creating these scenarios we can get a realistic view of how a portfolio, as a sum of its parts, could perform going forward.
- Predictability is key. Is the process repeatable?
With any strategy, it’s important to know if an investment manager is employing principles that can be repeated in the future. By combining risk metrics with portfolio analysis, it can reasonably be determined if a manager relies on luck, or some fortuitous positioning at one point in their career that has made their track record appealing. A good manager will have achieved success in multiple market environments using a repeatable, adaptable strategy. This is key in an ever-changing marketplace.
- Set knowledge-based expectations. Ask yourself, “How educated am I?”
Having proper expectations is very important for both the client and the advisor. The “Holy Grail” investment that always goes up and never goes down simply does not exist. Inevitably, there will be some losses as part of the process of creating wealth. Good planning, however, requires the investor to be knowledgeable, aware and educated on their portfolio. Study on your own to learn about your investments. Also, ask yourself if your advisors and the managers they work with are transparent. Do they work to help you understand how your money is invested? It’s important to work with a team who views your portfolio holistically and communicates a variety of potential outcomes with you. Having a solid foundation of knowledge around how and why gains and losses could occur fosters sound decision-making.
Whether you can sleep through an earthquake, or if the slightest shift causes you to seek shelter, remember, your risk tolerance isn’t the determining factor in a rational portfolio. The investor-advisor dialog is the difference. Ask the questions. Know the answers.