Behavioural finance: Why is it so relevant in the field of investing?

I was delighted that Richard Thaler was awarded the Nobel Prize for Economics last week. Thanks to the work of Thaler and other giants in the field of behavioural economics like Daniel Kahneman and Amos Tversky, it is increasingly accepted that "homo economicus," the rational agent always seeking economic advantage, does not exist.

Instead, it is now understood that when we make economic, financial, and investment decisions, we do so as flawed humans with an inbuilt tendency to do the wrong thing. Recognising this is the first step towards changing our behaviour for the better.

Thaler's particular contribution to this debate is the power of the "nudge," the idea that people need to be prodded towards making decisions that will improve their lives. Whether those decisions are about eating healthily, driving safely, or making sensible decisions about saving and investing, we all need to be nudged in the right direction.

Behavioural finance is particularly relevant to the field of investing. Many of the mental shortcuts--or "heuristics" in the jargon--that have evolved over the millennia have helped humans survive and develop but tend to make us bad investors.

The quick recognition of patterns in our environment has historically helped us spot danger and avoid it. But the necessity to make these kinds of judgements very rapidly in the jungle or out on the savannah has meant that humans have developed two distinct ways of thinking--fast and slow, instinctive and analytical, system 1 and system 2 in the behavioural literature.

Fast, instinctive, system 1 thinking is great for survival. It is generally pretty unhelpful when it comes to making investment decisions. These are better served by slow, analytical, system 2 thinking.

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The problem is that system 1 thinking is much more powerful than its rational system 2 counterpart. At times of stress it kicks in and overrides our rational brains. And there are few more stressful environments than financial markets when our life-savings are at stake. Overcoming the biases that all investors are prey to is key to managing our money successfully--and very few of us manage it.

One of the more important biases that influences our investing behaviour is called loss aversion. It refers to our tendency to feel the pain of losing money around twice as intensely as our enjoyment of making it.

This goes some way to explaining why most savers and investors are too cautious--why so much money is parked in cash and other perceived safe havens despite overwhelming evidence that sheltering in a persistently low-yielding asset will make us progressively poorer over time.

Confirmation bias is another important behavioural tic that can prevent us making sensible decisions. It describes our desire to seek out information that supports our prejudices. The ever deeper understanding of our preferences, interests, and opinions by the likes of Google, Amazon and Facebook means these cognitive loops are going to get ever more closed. The election of Donald Trump was the most obvious triumph for the manipulation of confirmation bias.

A related bias is known as the endowment effect, our willingness to ascribe a higher value to what we own than what we do not. If you have ever bought or sold a house, you will recognise this. The house you are reluctantly selling is self-evidently worth more than that insulting offer the estate agent conveys to you. Meanwhile, the owners of the house you are looking to buy are obviously deluded in holding out for such an unrealistic price.

Anchoring is one of my favourite biases because it shows just how irrational we can be when it comes to our investments. The famous example of this is an experiment that asked people to write down the last three digits of their phone number multiplied by 1,000 before making estimates of house prices. The higher the phone number, the higher the estimates.

A related bias is herding. Ask someone what the average height of a giant Redwood tree is and then see how their answers are influenced by other people's equally ill-informed guesses.

So, behavioural finance matters to us as individual investors, but it also matters at a broader societal level too. And this is why Thaler fully deserves his prize and the $1.1 million reward that went with it.

His work on nudging people towards better decisions was instrumental in the design of arguably the most important recent change to our pensions system. Fifteen years ago, the government recognised that a significant squeeze on pensioner incomes was around the corner and it understood that the prevailing system of tax incentives for pension saving worked better in an imaginary world populated by homo economicus than a real one full of flawed humans.

Auto-enrolment recognises that you don't need to make saving compulsory. The irrational human inertia that had stopped people saving enough could be turned on its head to ensure that they stayed signed up to their company pension. The proportion of people saving into a private pension has risen in five years, the pensions regulator calculates.

Back to investment, the most successful investors I have worked with over the years have been those with the ability to master their emotions, to override the human biases that make successful investing so difficult for the rest of us. Anthony Bolton and Jim Slater were very different people and investors but they shared this ability to park their emotions, shut out the noise, and swim against the tide.

James Montier in his definitive study called Behavioural Investing, says investors should accept that these biases apply to all of us and focus on the facts, not the stories. As a boss of mine once said: "In God we trust; everyone else brings data."

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Tom Stevenson is an investment director at Fidelity International. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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