However, as with so many things in life, our emotions often get in the way of this rational approach. We buy shares in a company solely because a friend recommended it. Or, we innately believe the higher-priced product is always better, even though we have no evidence to back this gut feeling.
Those are just two examples of how our brains may mislead us when we ponder money. We're supposed to be rational, but more often than not, we are often irrational.
Understanding the general tenets of behavioural finance can help investors counter irrationality and improve investment decisions. It studies the psychology of financial decision-making and is based on a sub-field of behavioural economics. This field of research began when economists noticed that a pillar of economic thought known as the efficient market hypothesis often wobbled in the real world.
Its hypothesis posits that in a market with enough buyers and sellers, and where all investors have the same information, it's impossible to beat the market. But some investors do beat the market, often by capitalising on the irrationality of others. This caused economists to try to discover why.
And here's five key concepts from their findings:
Anchoring: This refers to the tendency to depend on, or get anchored in, limited information - some of it irrelevant to the matter at hand - to make decisions. Investors sometimes get anchored in certain numbers, which may influence whether we perceive a share price or market index to be high or low. A company share make look like a bargain if it falls from, say, $100 to $80, but the drop in price may not be relevant. The relevant question should centre on the company's expected return over a time horizon. And that is not an easy or straightforward answer.
Herd bias: Every time parents ask their children whether they would jump off a cliff if their friends did, they are actually referring to the concept of herd bias, the tendency to hop on a trend because "everyone else is doing it". The dot-com boom and bust is one of many examples of the dangers of herd bias.
Home bias: The preference for sticking to the familiar has often resulted in investors investing in the shares of the country where they live even though diversifying internationally can generate stronger returns and lessen volatility. Home bias is especially prevalent in Australia. Australia accounts for just 2% of world markets, but figures show that Australians put 61% of their share investments in local companies. More research found the same effect affecting property investors, prompting them to invest in their own neighborhood, or close by, which may concentrate risk.
Attention bias: Advertisers count on attention bias. People are more likely to buy something they have heard of. So are investors. Research suggests that people are more likely to invest in companies they have casually read about or heard about on the news, for example.
Endowment bias: People tend to hold on to investments they already own, perhaps because they suffer from loss aversion. This bias has sometimes resulted in investors holding on to money-losing investments simply because it's painful to own up to a mistake.
Awareness of how our brains sometimes cause us to make poor choices can be the first step to making better ones.
Fortunately, there are shortcuts that can help you break these behaviors.
One simple solution is to adhere to four simple principles that will help improve the chances of a successful investment portfolio – goals, balance, cost and discipline. Set your goals, choose a number of well-diversified managed or exchange-traded funds with strong long-term track records. Keep your investment costs low. And finally, maintain long-term perspective and a disciplined approach to your investment strategy.
At the very least, you'll be less vulnerable to buying that share you just heard about on television.
Written by Robin Bowerman
Head of Corporate Affairs at Vanguard
18 October 2019
For more than 20 years, Sam has been a financial planner helping individuals and families achieve their financial planning goals, by providing advice on Investment Planning; Insurance Planning; Tax Planning; Retirement Planning; and Estate Planning. Working with a network of highly skilled professionals in Sydney he is dedicated to providing high-quality advice and integrated wealth management solutions that simplify and enhance the quality of his clients' lives.
Sam established his own firm in 1997 and has overseen its steady development and growth. Attention to detail, good listening skills and great empathy are symbols of his appreciation by his clients. He has built long-term relationships with his growing client base and aims to provide excellent customer service.
Sam began his financial planning career in 1993 after completing a Bachelor of Science degree in 1991. Since this time he has accumulated many professional qualifications such as:
Sam has volunteered with the Cancer Council of NSW and can be seen almost every year volunteering or participating in the 7 bridges walk.
Away from the business, he enjoys spending weekends with his son. He is also a football (soccer) tragic and is a massive Chelsea FC fan.
Having worked for national financial planning companies in the past, George has extensive experience in the provision of advice in risk insurance, investments and retirement planning and is focused on forming long-term relationships with his clients.
George has been awarded a Masters of Commerce (Financial Planning) and a Bachelor of Commerce through University of Western Sydney as well as having the Diploma of Financial Services (Financial Planning).
Jane Lim is a friendly character with a bubbly personality. She has the unique ability of making complex information sound simple and easy to digest.
Jane entered the financial services industry in 2006, and worked with big blue-chip financial companies such as Count Financial Limited and AMP Financial Planning Pty Ltd.
She holds a Master's degree in Applied Finance through Macquarie University, and she is a member of the Million Dollar Round Table.
Being a self-confessed "tennis nut", Jane spends many weeknights in the tennis court, and is a frequent member of Sydney's Eastern Suburbs Tennis Competition.
Being a highly motivated professional, Jane is always eager to help her clients on a wide range of financial planning needs.
Paul has been a financial planner for over 15 years helping individuals and families successfully achieve their financial planning goals. He is very focused on building successful long-term harmonious relationships with his clients.
He provides a holistic approach on various aspects of financial advice encompassing areas such as Investment Planning; Insurance Planning; Tax Planning; Retirement Planning and has extensive experience and knowledge in these fields.
Paul's professional qualifications are:
Away from his professional life, he enjoys spending his time with his family doing various activities such as coaching his son and taking him to games. He is a very avid sports fan and a cricket enthusiast.
Client Services Manager
Christian joined Capitalwise as Client Services Manager, with backgrounds in both customer service and administration.
Christian is passionate in providing excellent customer service by being attentive to client’s need as well as being able to circumnavigate challenges.
He holds a Master's degree in Commerce specialising in Marketing through the University of New South Wales.
Volunteering is one of his delights in life, where he had spent time being involved with the Centre for Volunteering, St Vincent de Paul's Society, and Sculpture by the Sea in a variety of positions.
Jenny is a University of New South Wales graduate who joined the team as an Administration Assistant. She is keen to put her customer service and organisational skills to use, making sure day to day operations run as smoothly as possible.
Outside of work, Jenny focuses her efforts on karate and ice hockey. She can often be found coaching and practicing karate at her alma mater. The rest of her time is spent at one of Sydney’s many ice rinks playing, practicing, or officiating ice hockey.
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