Being aware of individual behavioural biases is a vital part of the investment process, according to Daniel Kahneman, Nobel laureate and author of Thinking, Fast and Slow.

Research in the field of behavioural finance can be used for "good or evil," he told Morningstar's behavioural scientist, Sarah Newcomb, during an on-stage discussion at the Morningstar Investment Conference 2018, Chicago, in May.

In the worst case, knowledge of these biases could be used to exploit people. In the best case, it could help in the development and implementation of a financial plan, and potentially improve outcomes.

Agreeing on their own best interests should be the first step for any investor speaking with a financial adviser. The next is to find some way to develop a "regret proof" policy – a policy someone can live with when things go badly.

behaviour psychology investor decisionmaking

 

Understanding behavioural biases can help in developing a financial plan.

Kahneman described a practice he had developed with colleagues to improve investor outcomes. This initially involves determining clients' loss aversion, to enable "projected regret" to be measured.

"We try to have people imagine various scenarios. We ask them, 'at what point do you think you would want to bail out?'" There are some differences, Kahneman says, but he has found that even extremely wealthy people are loss-averse.

Two-part portolios to manage risk

The next step is to run portfolios in two parts. One portfolio holds the assets the investor is willing to risk; the other comprises assets that are viewed much more conservatively. The portfolios are managed separately, and individual reports prepared on each. 

Kahneman believes this is helpful for investors because, regardless of the market environment, one of the portfolios is likely to do well. Though the two portfolios aren't materially different, framing it as two separate accounts helps the investors understand and tolerate the risks better, he says.

Asset allocation is easy

Kahneman views the asset allocation component of investing as the easy part, and setting reasonable goals and adhering to them as the most difficult.

"Individuals tend to do very poorly guessing what stocks will do. Admitting you don't know is a very healthy step, but this admission leaves you with a great deal to do," he said.

Investors must be realistic about the potential outcomes, according to Kahneman, with professional financial advice useful in helping to make informed decisions. By discussing the risks in advance, investors can be better prepared for contingencies.

 

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