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19 April 2016
Want to get your head around investment behaviour? Read the start of our series below.
Welcome to the first part of our Investment Psychology series, this set of blog posts will cover some of the most important but often overlooked elements of investing, discussing the not-so-sexy topic of Market Psychology. The first part covers conventional theory and upon the end of our series, you will have gained a much stronger understanding (and mental awareness) of the importance of ‘using your head’ when it comes to your investments.
Looking at historical precedents, it is clear from the many “manias” (“Tulip mania”) and “bubbles” (“South Sea/ 1929/ internet”) that there are periods when the investing public gets a bit too exuberant about share investing. This aspect to investing i.e. when the public gets too involved creates a problem for central bankers. This article looks at the Investment Psychology principles and behaviours that have applied to investments and trading since it all began.
“The central bankers’ job has always been to take away the punchbowl just when the party gets going”; Federal Reserve Chairman William McChesney Martin 1951-1970.
The challenge for the investing public is the ability to recognise and respond to investment biases. This is particularly relevant when bias creates crowd or herd-like behaviour that impacts investment returns – a good thing if you are ahead of the crowd, a bad thing if you are last in the queue!
[bctt tweet=”The challenge for the investing public is the ability to recognise and respond to investment biases.” via=”no”]
We need to recognise and understand bias at both individual and crowd level and be armed with the tools we need to avoid being affected by bias. Bias is inherent in many views of the world.
Conventional theory holds that markets are “efficient” i.e. they move to price in good and bad news when it occurs, that market returns “revert to the mean” i.e. 8% return per annum. “Efficient market hypothesis” still holds up to a point, but its underlying assumption that markets move quickly to price in information has taken a knock in recent years, with the frequent appearance of “black swan” events.
This describes a high impact (negative) event that was thought (before it happened), to have such a tiny chance of occurring that it was discounted in decision-making models. A “black swan” disproves earlier assumptions.
A “black swan” was presumed to not exist and was undocumented until the 18th century.
Both the US subprime crisis and its consequent development into a global financial crisis in (2008/2009), the Japanese earthquake and tsunami (March 2011), Greek crisis (2012) have been cited as Black Swan events. By their nature, the impact of big events is unpredictable, difficult to grasp and have behavioural implications. The impact of large events can continue for prolonged time periods.
What thought processes can be used to guide investors through the maze?
Behavioural finance tries to explain how emotions and cognitive errors influence investors and decision making. It is easy to notice the emotional impact of investment decision making. Indeed, I have observed individuals go from elation to depression in seconds as a result of small share price movements. This is partly because people respond to uncertainty in different ways. Behavioural finance seeks to pinpoint patterns of behaviour that are relevant to investment decision making.
This is partly because people respond to uncertainty in different ways. Behavioural finance seeks to pinpoint patterns of behaviour that are relevant to investment decision making.
The human brain uses shortcuts and emotional filters to categorise information and save time. Having bought an asset, investors will focus on good news that supports that decision and filter out “bad” news that questions that decision. These are called psychological biases and may result from the need to seek comfort and order where it does not exist. Success is attributable to personal skill, with failure as “someone else’s fault”.
Investor rationality requires investors to be dispassionate and objective. This is easier said than done. Investments are forward-looking in nature, or at least they should be, however, the only evidence for understanding the future is a knowledge of the past. This helps explain why facts supporting evidence are vital to investment thinking.
Part 2 will be published on Monday 25th, keep your eyes peeled as we help you understand spending perspective and present you with a joy versus pain model.
If you’re new to the CSS Investments blog, please make sure you read our introduction post here to find out how this blog will help you become a better informed investor or trader.