Investment Advice

Investors are strange creatures!

• “I knew it was going to be bad but I’d already bought the ticket”.
• “I’m not investing money into that until the value has gone up 20%”
• “I’ll sell it when it gets back to the price I paid”.

Why do we behave irrationally? Why do we sit in a cinema watching a bad film just because we bought the ticket? Are we not simply suffering the consequences twice? We would not wait for the price of our morning coffee to go up 20% before buying it, so why do we do this with investments? Why do we hold onto things which have dropped in price, when selling them and moving on would get our money back quicker?

Many theories abound. Right back to economists like Adam Smith, many have sought an explanation of why markets behave as they do. One that has gathered force of late is behavioural finance.

Behavioural finance suggests people often make decisions based on so-called rules of thumb, rather than after rational analysis. Technically referred to as heuristics, it involves understanding that the way a problem is presented to a decision maker can affect the outcome (a process called framing) and market inefficiencies are not the only way to explain outcomes that go against rational expectations.

Two of the most influential psychologists in the field are Daniel Kahneman and Amos Tversky who, in 1979, published a paper comparing models of rational economic behaviour with decision-making during times of risk and uncertainty. Their theories sought to explain anomalies in the way investors and financial markets react.

These theories help to explain how we can all get pulled into phenomenon such as the technology boom (usually too late to actually make money), despite the irrational theories which often support them. It helps explain why we sell out of a falling market, just when our loss is at its greatest. It explains why we hold on to ‘loved’ investments. And it is why we shy away from markets which have underperformed, despite indications of great potential.

Increasingly, asset managers are using pricing models to take behavioural biases into account, as they believe it gives them an advantage. If you understand these theories, you could have that advantage too. It can be difficult to turn your head against the herd when it is stampeding towards you at full speed – but long-term, you may be very glad you did.

© 2009 Paul Parr – Financial Planner.