Ever heard of behavioural finance? It’s a social science that explains why people buy expensive things, sell cheap ones, and make all sorts of other rash decisions that can torpedo their asset allocation – and ultimately their wealth. We can make better decisions and improve the way we shield and grow our wealth, however, by understanding how we think.
Of course, we’re all emotional beings. When under pressure it’s usually a case of fight or flight. And, when things are going well, it’s hard not to get carried away.
But some of these perfectly natural traits can be unhelpful when it comes to your own money. They can lead to problems in asset allocation.
In fact, so commonly are these natural responses used in financial decisions, and so often do they go wrong, that there’s a whole branch of social science devoted to it: behavioural finance.
The Chartered Accountants’ trade body – who know a thing or two about finance – describe behavioural finance as follows[i]:
“[It] attempts to explain how decision makers take financial decisions in real life, and why their decisions might not appear to be rational every time and, therefore, have unpredictable consequences. This is in contrast to many traditional theories which assume investors make rational decisions.”
This irrationality can lead to mistakes in your asset allocation strategies.
What is asset allocation?
This is the term we use for decisions about where your money should be invested, such as shares, bonds, property, cash and so on. It also describes the options within these asset classes, such as UK companies versus international, or government bonds against corporate bonds.
But it’s not just about where your money goes; it’s about how these assets fit together in terms of risk and reward. It’s how they balance against each other because if one portion goes down, you’ll need another to be going up at the same time to balance out any losses.
It can be simple to get right – and just as easy to get wrong, as behavioural finance shows.
Five mistakes in asset allocation
- People can get get overconfident and assume they know where a stock market, investment or house price might be heading. In 2006, a survey of professional fund managers (people who make strategic asset allocation decisions for a living) found that 76% of them through they were above average at their job![ii] Their over confidence can easily mean incorrect decisions or unnecessary trades.
- If you’re convinced you know pricings are going up, you might compound this mistake through confirmation bias. This means focusing on information that confirms your thesis and discarding information that challenges it. This selectivity runs contrary to the idea of evidence-based investing (where you allocate assets according to facts and empirical data).
- Sometimes we treat different pots of money differently. We probably all tend to think of a windfall or a tax rebate as more like ‘fun’ money – because it’s not always expected. And we often look at hard-earned money very differently. This mental accounting bias can make you misdirect portions of your wealth, with windfalls into riskier assets and earned money into safer ones, regardless of your actual goals.
- Pain and pleasure are very different sensations. Even with money. People tend to feel the pain of losing a sum of money a lot more than they do the pleasure of gaining the same sum. This loss aversion bias can make you monitor and tinker with your money too often – sometimes at the expense of long-term goals.
- A less common – but no less unhelpful – mistake is anchoring bias. In other words, if you think something is worth £X, perhaps because it first looked a bargain at £X, then £X is the price you would be willing to pay for it – regardless of material information or whether £X offers your overall portfolio value.
How to avoid rash decisions
Right now, the CNN “fear and greed index” – yes there is such a thing – is set to ‘greed’[iii]. This means that investors in American shares are over-excited about the prospects of those shares, are investing hungrily at prices that are slightly too high, and therefore driving those prices up further.
If you’re one of those people that doesn’t like overpaying for things (in investment you’re called a ‘value investor’ because you seek good value companies) this isn’t a happy hunting ground.
Following the herd can seem attractive: “do they know something I don’t?” “What if I miss out?”. But such a behavioural finance trap can lead to rash decisions – and there are plenty of techniques to avoid them.
- Setting a goal and working out what sort of risk you can tolerate will be a big help. Then, every decision you or your wealth manager makes can be examined in terms of its relation to your goal and appetite for risk.
- Keeping a long-term perspective is also crucial. The chances are you’re investing for targets on a horizon that’s pretty far away, such as retirement or building a pot for your dependants. In this case, time is always your friend and short-term tinkering and tampering is often the enemy.
- Changes might be necessary. But not ones driven by fear or greed. Sensible rebalancing of your asset allocation – say, a slightly higher proportion of bonds and commensurately less in shares – will be needed if there are any changes to your targets or your personal or financial situation.
- Lastly, the value of good, professional advice cannot be overstated. This is someone with a deep understanding of the evidence behind investing, who can help you set reasonable and measurable goals, and who can – if need be – gently challenge you on decisions in light of that evidence and goals.
Add these all together and you will have a better chance of avoiding the rash decisions that are so often the consequence of misunderstood behavioural finance. Without rash decisions, your asset allocation will likely be calibrated perfectly for your needs.
This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.