We have already explored this subject in some detail in the articles “Psychological pitfalls to avoid when investing” and “Behavioural finance: making more rational investment decisions”.
Behavioural finance: strategies to help protect yourself
Research into behavioural finance has uncovered a whole host of systematic mistakes that investors make for all sorts of reasons. Here we’re going to explain how you can apply the theory of behavioural finance in practice, and how you can use it for your own investments.
The very first thing we need to do is acknowledge that we all tend to behave irrationally. Behavioural economics continues to show countless examples of this, including ones involving experts behaving irrationally in their own area of expertise.
Studies conducted by renowned authors such as Daniel Kahneman, Amos Tversky and Richard Thaler show us that this sort of behaviour is not unique to specific markets, it can occur in all sorts of different scenarios. Once we are aware of this fact, we will be able to view our decisions in a more level-headed light and with a more critical eye.
Long-term strategies trump short-term tactics on the market
A long-term attitude will additionally help us to avoid many of the most common behavioural mistakes. For instance, it is fairly unlikely you will be able to choose precisely the “best” day to purchase or sell an asset. Past experience indicates that a consistent investment strategy pursued over a long period of time will usually generate a higher return than short-term tactics. In other words, it is important to prioritize strategy over tactics.
Anyone who knows themselves well will be all too aware that potential short-term gains are very appealing. Short-term losses can result in rash decisions. One way to resist such temptations would be to apply the Hans-Jörg Naumer “Ulysses Strategy”.
Sticking with a rational decision
Naumer’s fundamental idea harks back to the classical hero Ulysses. Ulysses has to overcome a series of dangers, one of which is to steer clear of the rocks of the sirens and come out unscathed, along with his crew. Sirens are well known for their beautiful singing that serves just one purpose: to lure sailors to their deaths on the rocks.
Ulysses wants to survive the journey, but still hear the singing of the sirens. The solution: he blocks the ears of his ship’s crew and has himself tied to the ship’s mast. And so, try as he might to tear free of his shackles, he is unable to break free of the mast, and his crew do not succumb to the singing of the sirens because of the wax in their ears, and they successfully steer clear of the rock.
The lesson for investors is this: decide on a strategy and stick with it. Do not be influenced by the “siren singing” of the capital markets, which could well lure you into a frantic back and forth when it comes to investing due to the endless stream of new information they shower us with. Be sure to keep on track.
This often applies to careful investors in particular who keep too close an eye on how their investments perform. Seeing as they struggle to tell the difference between price fluctuations and legitimate drops in value, they have a tendency to abandon their strategy and sell prematurely if prices dip for a short period of time.
One way to help you persevere is an asset allocation fund. These combine different asset categories in a way that fits your personal investment strategy. Depending on the type of fund, they contain varying allocations of shares and bonds. This means investors are less tempted to react immediately to short-term changes in individual assets, and so less likely to fall victim to the behavioural finance pitfall.
Buy and hold – making a return by doing nothing?
Another strategy is to persevere with assets once you have purchased them. If you choose this strategy, then as an investor you are proceeding on the assumption that nobody really knows how prices will behave, and that nobody can gain the upper hand with “insider knowledge”. If you stick to this strategy in the long term, you will also avoid making any wrong moves as far as behavioural economics is concerned.
According to the efficient market hypothesis devised by Eugene Fama, this is the best strategy seeing as it assumes markets are efficient. However, if you never adjust your portfolio in the long run, you will be unable to respond to innovations and structural changes on the market.
Are index products the best option from a rational perspective?
Index products such as exchange traded funds (ETFs) may help solve this problem, at least in part. These products reflect market changes in your own portfolio in a very cost-effective way. Nevertheless, if you purchase index products, you are effectively jumping on the bandwagon, and will struggle to refrain from “herd behaviour”.
Thorsten Hens, Professor of Financial Economics at the University of Zurich, also explains that a financial market would cease to function if all investors opted for nothing but buy-and-hold strategies. This means investors would no longer care what happens on the stock exchange the following day, and they would only have a long-term investment horizon of at least ten years. Market prices would no longer reflect the future development of companies, and there would be serious investment mistakes.
Diversification remains key
A diversified portfolio helps ensure investors do not overestimate themselves. In behavioural economics, these instances are known as “behavioural biases”. If you diversify your portfolio on a consistent basis, you will avoid succumbing to “home bias”, in other words purchasing a disproportionately large quantity of assets from your home country.
You should also ensure you diversify strategically. Many investors fall victim to what is known as “naive diversification”, and do not base their decisions on rational arguments, but experience. When it comes to selecting financial products, pay close attention to their composition, as it should be compatible with your investment strategy.