The Hidden Influences of Your Brain: Part 4 – Behavioural Investment Strategies

posted on February 24th, 2016 by Bellmont Research Team

This is the fourth of 5 posts that discuss how to use insights about your brain to become a better investor. In the first two posts (post 1 and post 2) we discussed behavioural biases as they impacted Mark & Meg’s decision to buy a car, and as they made a number of investment decisions. In the third post (post 3) we examined some market impacts that result when many investors are impacted by the same biased decision-making. In this post we will consider 5 strategies Mark & Meg may wish to employ in response to behavioural finance insights.

1. Self-awareness

The first step in the process is self-awareness – making sure you have a good understanding of the major biases you are likely to be impacted by. Even better is if you can understand how and when they operate, and the implications for your financial future. This understanding needs to be tailored to your investment personality. Meg’s relatively less engaged approach to investing, her lower level of comfort and interest with investment concepts, and her lesser experience, expose her to different risks and biases than are relevant for Mark.
However, because of their deep-seated, emotional and often subconscious nature, education by itself is unlikely to be sufficient.

2. Coaching

It’s often hard to identify behavioural biases in yourself. It’s much easier to do it with someone else. In this way, having a sounding board to bounce investment ideas off can be helpful, particularly if that sounding board is trained in behavioural finance. Depending on the need, a financial adviser, investment adviser, accountant or knowledgeable friend could play this role. Mark & Meg’s willingness to delegate responsibility for their investment decisions differ, so an adviser would need to be able to flex their approach accordingly.

3. Systematic processes

Developing a policy-driven, systematic approach to investing can reduce the scope for behavioural biases to affect decision-making. By establishing a set of investment rules to apply, you are able to make investment decisions while being removed from the real-time context in which decision-making traps may be most powerful.

An investment rule that Meg might apply could relate to maintaining a maximum amount of cash at any time, for example. This could help reduce the risk that she sells down in response to a market decline and remains under-invested during a subsequent rebound. Mark’s investment rules could include a requirement that he defers executing any trades for 24 hours after deciding on a trade. This would limit the risk that he is affected by short-term news and or other emotional drivers.

4. Portfolio design

Much of the benefit of understanding behavioural biases is simply reducing the biases that detract from financial performance: staying fully invested, staying diversified and avoiding high-risk investment strategies. In addition, these Posts have highlighted a number of behaviourally focussed approaches that can allow both Mark & Meg to potentially capture greater returns.

  • Value effect: Meg, for example, could consider investing in an Australian Equities Fund that has a bias to value stocks. Similarly, as he prefers to be self-directed, Mark could apply a value-based filter to his investments.
    • Momentum: Mark could analyse recent historical returns as a gauge of short-term momentum to factor into his investment decisions.

  • Downside protection: If Meg is feeling apprehensive, an investment structure that mitigates the downside risk may help her stay invested. Even if it resulted in lower return, the benefit of helping her stay in the market may enhance her long-term outcomes. Some strategies to achieve this may include investing in portfolio with a buy-write option overlay (which captures the option value discussed in post 3), or a fund that performs well in falling markets. For Meg, these approaches are likely to be a more efficient way of allowing her the emotional comfort she needs than either reducing her equities exposure (which could substantially reduce her long-term returns), or buying portfolio insurance (which may be expensive, for reasons we discussed in post 3).

5. Feedback & learning

Why do behavioural biases persist? Why don’t we learn from our mistakes and correct them? One reason is that we often don’t receive the right information to help us learn. For example, when Mark sold Tintop, the feedback he received seemed positive: he made a profit. However, if he received feedback that showed he systematically sold his winners, if he saw that they continued to rise after he sold them, and if he added up the capital gains tax he incurred; perhaps his conclusion would be different.

Another reason we don’t learn from our mistakes is that even when we do receive the right information, there are biases in the way we attribute meaning to that information. When an investment turns out well we tend to attribute it to our investing prowess. When it goes badly, we often believe it was the result of something external to us. The good news is that these biases help to boost our ego and protect us from anxiety. The bad news is that they provide a barrier to effective learning, and a barrier to improved financial outcomes.

Seeking out appropriate information reduces the chance to misattribute meaning. For protection against self-serving attribution biases, a behavioural finance-aware adviser could provide the necessary reality check.

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About the Author:

bfa

Simon Russell, Director, Behavioural Finance Australia
For news, articles & events related to behavioural finance, you can join Behavioural Finance Australia’s mailing list via their web site at www.behaviouralfinanceaustralia.com.au. BFA does not provide financial or tax advice. Please consult your appropriately licensed financial or tax adviser or exercise your own judgement prior to making any investment decision. Full terms and conditions are available on their web site.



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