Managing your emotions and taking them into account when making financial decisions is one of the principles of behavioural finance, which melds psychology and economics. Sarah Newcomb, senior behavioural scientist with Morningstar's Behavioural Insights Team, explains how recognising our innate biases can help us make shrewder decisions.

What is behavioural finance and how did it come about?

Behavioural finance is the intersection of the fields of psychology and economics. It is the science that describes the psychological aspects of financial decisions - especially where the decisions deviate from simple models of utility maximisation and rational behaviour.
The two fields have had crossover for centuries, but only become widely studied in the past few decades.

How can retail investors use it to bolster their investment strategy?

In my opinion, investment strategies based on trying to predict herd behaviour or exploit the biases that lead to irrational market behaviour are not the most useful applications of behavioural finance. I may be very much in the minority on that point.

Rather, I think we are better served by the science when we use it to recognise the ways our own irrational biases might stand in the way of making solid financial decisions. For example, we know that loss aversion makes us more sensitive to dips in the market than spikes.

With this in mind, we can do our best to hold back from checking our investment balances on days when the radio and TV are blowing up with doom and gloom, and keep our focus on the end goal instead of the ride.

Is there a particular event – such as the 2008 global financial crisis – that behavioural finance specialists think holds valuable lesson for investors?

I think it's not the crisis itself but the decade that followed that teaches the real lesson. Those who remained invested through the ordeal rebounded and regained their lost assets, whereas those who abandoned their investments often lost their shirts.

The goal isn't to have no emotions in our financial dealings, but to manage them effectively and make sound decisions in the presence of those emotions and in spite of the biases.

behavioural investing biases economics sarah newcomb

Loss aversion makes us more sensitive to dips in the market than spikes

Recent research* by economists Nicola Gennaioli and Andrei Shleifer suggests an awareness of human irrationality can help us predict booms and busts. That is, we can avoid busts by recognising that when asset prices rise, investors pile in and pump up prices even more. Eventually the money runs out and a crash ensues. Do you agree?

We may be able to predict booms and busts, but can we avoid them? I don't know. What the idea amounts to is contrarianism, which can be a very successful investment strategy but is still essentially trying to time the market. I think that following a value-driven, long-term investment strategy is the best course of action.

That said, the findings from articles like this can be great motivators to stay clear of 'hot tips' and beware of fads and trends, and stay the course because in the long run things revert to their fundamental value.

What are some Morningstar resources retail investors can use?

This year marked the start of the Morningstar Investor Success Project which features new research on investors — who they are, what their goals are, and how the advisers and asset managers that serve them can make the most impact in helping them reach those goals.

* http://papers.nber.org/conf_papers/f114470/f114470.slides.pdf. A Crisis of Beliefs: Investor Psychology and Financial Fragility, July 2018

Sarah Newcomb is Senior Behavioural Scientist for the Morningstar Behavioural Insights Team

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Lex Hall is content editor, Morningstar Australia

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