What is behavioural finance? What behaviours prevent us from making the right investment choices? How can we improve our investment decision making?
The study of behavioural economics allows us to better understand the decisions we make. We show how behavioural finance can lead to better investment decision making. We explore the inherent biases we must overcome to achieve our long-term investment goals. And we provide six tips to improve investment decision making.
Digging deeper, we look at ‘noise’, the random and irrelevant variables that affect our decisions. And we provide lessons from four books that changed the way we think about thinking.
Behavioural finance aims to influence – and hopefully improve – our financial decisions. It helps us understand the gap between how we should invest and what we actually do. This ‘behavioural gap’ can come with a significant cost – sub-optimal investment performance.
An understanding of our own behaviour should be at the forefront of every decision we make. We exhibit a number of biases in our decision making. While we cannot remove these biases, we can seek to better understand them. We can build more systematic processes that prevent these biases adversely influencing the decisions we make.
Investors should focus on those biases that are most likely to impact their investment decisions – and those supported by robust evidence. We have developed a checklist to reduce errors from the key behaviours that affect our investment decisions – ‘MIRRORS’.
Our decisions are affected by noise; random fluctuations in irrelevant factors. This leads to inconsistent judgement. Investors can reduce the effects of noise and bias through the consistent application of simple rules.
We offer six simple steps to improve decision making; three dos and three don’ts.
- Do have a long-term investment plan.
- Do automate your saving.
- Do rebalance your portfolio.
- Don’t check your portfolio too frequently.
- Don’t make emotional decisions.
- Don’t trade! Make doing nothing the default.
These six steps seem simple but are not easy. We cannot remove our biases, or ignore the noise. Instead, we must build an investment process that helps us overcome them.
Joe Wiggins, Fund Manager
Joe completed an MSc in Behavioural Science at the London School of Economics. He was awarded the Brian Abel-Smith Prize for outstanding performance. He writes a blog on behavioural finance.