“Wall Street has a few prudent principles; the trouble is that they are always forgotten when they are most needed.”
– Benjamin Graham
The study of behavioural finance, a sub-field of behavioural economics, arose in the 1980s. Since then, we have been learning more and more about how our emotions, biases, and blindspots affect our money-making choices and can hinder our investing outcomes.
This is contrary to traditional financial theories, which failed to take human behaviour into account and instead were based on the assumption that in any given situation humans make rational, economically-sophisticated choices by considering all the relevant information available.
The recognition that part of being human is that we are all prone to biases and emotional thinking helps create an awareness that can help us in our approach to investing (and life in general).
It is helpful to consider the areas where the biases manifest themselves in real-life decision making. These can be broken down into four main areas – as follows:
1) Self deception –
Mistakenly thinking we know more than we do can prevent us from being able to make an informed decision;
2) Heuristic simplification –
When our decisions are impacted by information-processing errors;
3) Emotion –
When our emotional state interferes with rational thinking and affects decision making;
4) Social influence –
How others influence the decisions we make.
Financial biases span all of these areas and the most common of them include: projection and hindsight bias; overconfidence and underconfidence; self-serving bias; herding behaviour; loss aversion; anchoring; confirmation bias, the narrative fallacy, representative bias; and, framing bias.
To overcome our emotional influence to become an impartial investor it is important to have strategies that guard against these biases.
1) The decision-making process –
Focus on the process, not the outcome. This promotes reflective versus reflexive (thoughtful vs automatic) decision-making, making us more prone to deceptive biases and emotional and social influences. Reflective decision making requires more effort, but results in better decisions based on logical decision-making processes;
2) Commitment to a prepared plan –
Behavioural finance teaches us to invest by preparing, planning and pre-committing to our plan.
Let us at WellsFaber assist you to this end. By implementing the right principles and helping you commit to them – as we commit to you.