Behavioural finance’s role in investment decisions
September 8, 2016
Human psychology plays an important role in how individuals make investment decisions.
Many investors are their own worst enemy. The risk of how some people make investment decisions is often more significant than the risk of the investment itself.
The study of behavioural finance has grown significantly over the last several decades. Human psychology plays an important role in how individuals make investment decisions.
Have you ever asked yourself what you need to know in order to be a successful investor? Part of that answer might be to better understand your natural tendencies, and to avoid common human mistakes.
Many think that investing is the domain of economists and mathematicians. Those disciplines have their role, however, successful investing requires an understanding of human tendencies.
Financial theory suggests investors are risk adverse. They will avoid taking on excess risk and buy or sell investments in order to lessen risk.
This is great in theory, however behavioural finance has observed this is not always the case.
In the real world investors who are facing a potential loss will often take on additional risk in the hope they will recover that loss. Even when the best strategy is to sell, they continue to hold the investment.
The opposite is true when the investor has a gain. Those investors are risk adverse and are more likely to sell at a profit versus risk continuing to own that investment.
For example, assume one investor purchased two separate investments. One appreciated by 10% and the other declined in value by 10%.
Logically the decision to continue to hold or sell each investment would be based on the investor’s expectations of future changes in value of each investment.
In a perfect world the correct decision would be made. Investing is no different than other aspects of life and long-term success is often based on making correct individual decisions over time.
Investment success is difficult. After tax, after investment fees, and after inflation, it is very difficult for most investors to achieve the amount of returns they had hoped for.
Add to that difficulty, the fact that human behaviour is not always logical makes achieving long-term investment success even more difficult.
My recommendation is to accept human tendencies as fact and try to develop strategies that will help you resist making poor investment choices based on normal human behaviour.
The key is to accept the fact that you too share these human tendencies, versus being in denial and thinking you are different. You are different as an individual however financial research would suggest most humans make this mistake.
Another human tendency is to overstate the amount of risk they can tolerate. This can be dangerous during periods of stock market volatility.
Overstating the amount of risk an investor is prepared to take will be covered in next week’s column.
Human behaviour will play an important role in your long-term investment success. I encourage you to consider these variables in order for you to make better investment decisions.