A sizeable proportion of market movements are based on human emotion rather than the fundamental attributes of an investment. Behavioural finance recognises this inconvenient truth at the heart of investment, turning the spotlight on the factors driving investor behaviour and using them to make positive investment decisions.
It is not enough to understand how we feel as individual investors; we need to understand how the wider investment community feels - and identify the factors driving the markets. Behavioural finance recognises the emotions involved in making investment decisions under conditions of euphoria or panic, and enables astute investors to profit from this behaviour.
Many investors base the price they are willing to pay for an asset on their perception of its immediate potential, focusing on short-term newsflow and forecasts. However, these factors distract from the fundamentals, preventing the investor from viewing the investment as a long-term asset. Decisions are based on individual investors’ perceptions of risk and reward, which are, in turn, often dictated by broader sentiment-led trends of fear and greed.
It is worth noting that an approach based on behavioural finance is not the same as a contrarian* approach. Behavioural finance is not about going against the crowd. Instead, it helps the investor assess the extent to which the crowd’s emotion has moved prices inappropriately and then to use this information in the decision-making process.
Windows of opportunity
Human behaviour can influence markets over both the short and the long term. For example, the Dubai debt crisis of 2009 was short and sharp, while the European sovereign debt crisis has yet to conclude. Looking further back in time, the effects of the dot-com boom and bust can still be felt.
A notable episode of behavioural finance at play came in 2011 when an earthquake and tsunami hit Japan. While it could be expected that Japanese equity** markets would fall after the disaster, European equity markets dropped equally sharply – even though investors had little information on the likely impact of such a far-flung event on, for instance, German companies. Such episodes can offer investors a window of opportunity.
The courage of your convictions
The principles behind behavioural finance sound straightforward enough, but how can they be used to construct and manage an investment portfolio?
One approach is to be objective and investigate scientifically how much one is being paid to invest in a particular asset. By comparing the yield*** provided by, say, a government bond to that of a company share, an investor can objectively evaluate the relative attractiveness of each asset. However, this process has to be disciplined; the investor cannot then be swayed by the sentiment surrounding each asset (everybody may be buying government bonds (bonds issued by governments) at the moment, believing company shares to be too risky). This approach requires investors to have the fortitude to stick to their strategy. Not every investor is comfortable following behavioural finance techniques. It can be challenging to take decisions that appear to fly in the face of ‘normal’ investor behaviour.
Nevertheless, the principles of behavioural finance can be harnessed by any investor willing to accept that a sizeable proportion of market movements can be attributed to noise rather than hard fact. They can provide a valuable reality check, forcing investors to examine their decisions.
Ultimately, behavioural finance does not seek to ignore the human factor. Rather, it seeks to recognise it, acknowledge its important influence, and then strip it out of the analytical process in order to make successful investment decisions.
* Contrarian: an investor who does the opposite of what most investors are doing at any particular time.
** Equities are shares of ownership in a company. Equity investors have a claim on a company’s assets and profits (the latter in the form of dividends), but only after its debts have been paid.
*** The amount of annual income that an investment provides, divided by its current price, expressed as a percentage.