Traditional finance and investment theories such as Modern Portfolio Theory (MPT) and Capital Asset Pricing Model (CAPM), are based on certain assumptions about how investors behave including such as the following:
- Investors always behave rationally
- Investors are well-informed
- All investors have the same information available and will use it in the same way
- Investors understand all the information that is presented to them.
This isn’t the full list, but perhaps you can see some of the potential flaws in these assumptions?
Behavioural finance looks at the psychology and emotional factors behind making investment decisions, and identifies the mismatches between how investors are assumed to behave and how they behave in reality.
In other words, adding the human element to making good investment choices!
I’m not settling out to try and change any ones’ individual mind-set or personality here, but over the coming months, try to point our some of the issues I see with clients thinking and explain how understanding these behaviours can assist with making better decisions and avoid some of the common pitfalls.
We often can’t help being ourselves in everyday decision making and the odds are stacked against us when you realise that the principles of behavioural finance have been understood, used (and exploited) by the advertising industry since the 1950’s.
We tend to develop “rules of thumb” when we are faced with situations where decisions have to be made often.
They also tend to be highly personal and can lead to errors being made more often as each individuals rules will be subtly different to another.
Heuristics are defined in the Concise Oxford Dictionary as:
- Allowing or assisting to discover
- Computing proceeding to a solution by trial and error.
In behavioural finance these rules of thumb (or behavioural traits) are known as heuristics
There are many heuristics at play when it comes to investment decisions and the first I’m going to introduce to you is “anchoring and adjustment” – one of my particular favourites!
(I realise as I write this article, that I’ll be giving away all my secrets are there’s a good chance you’ll not believe a word I say in the future, and will challenge all my comments
Anchoring involves using a known amount as a starting point for estimating an unknown future amount.
For example in a) I could say to you assume that the FTSE100 is at 3000 points (and in reality its at 2879 points), what do you think it will be at by the end of the year?
I might also ask you in b) if the FTSE100 is assumed to be at 8000 points ( and is currently at 8253 points), what do you think it could reach by the end of the same period?
(both are hypothetical examples!!)
These are not perfect examples, but I’m hoping that perhaps your answer in a) might have been to underestimate and say 2900, and in b) to overestimate and say 9000
Where the anchor is lower, there is a general tendency to underestimate and the converse is true where the anchor is higher.
Salespeople often use this heuristic by suggesting an anchor to make a customer more receptive to what they are offering – “normally this would cost you £10,000, but tonight I can offer it to you for £7,500 if we complete the paper work right now”
There are many more elements to the whole behavioural finance and economics world, and I hope you find this initial foray in to the subject interesting.
The subheading of this series should probably be “Understanding how the mind can help or hinder investment success” and I will posting more on this subject over the coming months.
Please check back for further examples of heuristics and if you’ve any questions, please call me.