Behavioural Finance uses psychology to understand why investors make the financial decisions they do and can help identify common traps which investors fall into when making decisions.
In Part One of these articles about Behavioural Finance I introduced you to System 1 and System 2 and how some of the principles of modern economic theory do not actually fit with human behaviour.
We will all have our own reasons why we want to invest, what outcome we are looking to attain and why. Yet, we all exhibit similar psychological views when doing so.
An understanding of what these are can help us to avoid making inappropriate and potentially regretful decisions that could lead to portfolio performance which was unintended at outset.
We face many choices in life that can lead to either a positive or negative outcome, either a gain or a loss. Let’s consider a simple example:
You are offered a gamble on the toss of a coin. Tails you lose £100 and heads you win £150. The potential gain is greater than the potential loss, but will you take on the gamble ?
If you are like most people you will probably not accept the gamble.
Psychologists have carried out many experiments like this, asking people for their views on whether or not they would take on a particular gamble.
Research has concluded that we are generally loss averse, to the extent that the negative feeling we exhibit when say losing £100 will be about twice that of the positive feeling of winning £100.
Our aversion to loss lies in evolution history; by treating threats more urgently than opportunities we have a far greater chance to survive and reproduce.
Fiona and Clare invest exactly the same amount of money in the same portfolio. Over a 12 month period Fiona looks at the value of portfolio weekly and Clare every quarter. One year on, they have both made the same amount of money, yet the portfolio did move up and down throughout the year.
Who is likely to feel more comfortable with how their portfolio performed?
Fiona witnessed a greater number of falls and gains in her portfolio than Clare because she looked at the value more often. She is likely to feel less positive about her returns over the year, simply because she witnessed more losses than Clare when viewing the progress of her portfolio.
Loss aversion is at work, with a consequence being that Fiona may well feel inclined to adjust downwards her exposure to more risky assets and miss out on potentially more rewarding long term gains.
Some of the reference material used in this article has been taken from a book called “Thinking, Fast and Slow” by Daniel Kahneman.