Understanding Behavioural Finance, Part Three – How to invest well
The academic field is providing a framework around behavioural finance and understanding what investors want, as well as developing an ability to start to blend it into classical finance techniques. While at Barclays, Greg Davies built their investment process on an investment allocation model like anyone else who’s trying to maximise risk-adjusted returns.
For the first part of this series, click here, and for the second part, click here
Applying behavioural finance
“At its heart, we measure risk in a behavioural way. We’re plugging bits of behavioural science into our quantitative model, so that we’re measuring risk in a way that looks at what risk exists that matters to people.
You could argue that the really great investors have been doing this all along, even as far back as Adam Smith, who’s regarded as the founder of modern economics and epitomises the notion that humans should be rational all the time, but even he wrote a lot about moral sentiments and behavioural psychology.
This has always been the route to successful investing, it’s just that now we’re much more able to formalise it and build it into tools and quant models, to enable it to be democratised. You don’t have to be the world’s best investor to take these techniques and think about how you would use them.”
Understanding investor behaviour
I asked Greg if he could tell me about the specific behaviours that investors classically exhibit and what the effect of those behaviours might be:
“There are many, and part of the danger of the field is that a lot of what you might read about behavioural finance is very unhelpful. I saw a website that listed 169 different identified biases of psychological decision-making, which is useless!
The notion that we should be listing and categorising things in order to make them better is a nonsense, but there are more helpful frameworks to combine them. In Daniel Kahneman’s book Thinking Fast and Slow, he uses the notion of System One versus System Two. System One is the immediate, emotional brain, which is always turned on and is lightning-fast. Sometimes it’s astonishingly accurate in areas where we get good at recognising patterns. For example, chess Grand Masters who can glance at a chess board and instantly recognise the next best move aren’t thinking sequentially through that, it’s just pattern recognition.
The trouble with the emotional brain is that something always pops into our head, and it’s not always right. The other brain is the deliberative brain, the one that allows you to sit down and solve a problem by thinking logically and sequentially.
We can use that brain to check the answers that pop in from our emotional brain, but it’s taxing to do so, because it takes time and effort, so often we don’t use it. We run through life on auto-pilot, and most of the time this doesn’t matter too much.
But, financial decision-making is an area where our intuitive emotional response is often misaligned to the right answer, because it’s about abstract trade-offs and risk and return. It’s about thinking about what might happen in the future, and it’s an area unlike chess, where you can play 10,000 games and the rules stay the same. In investing, it’s difficult to build up the intuitive knowledge that is well grounded in repeated experience.
We can think of behavioural finance as: ‘How do I balance these two systems?'”
To put that into context with the mistakes investors make, most investors leave far too much of their wealth doing nothing – they under-invest, because the right level of risk for their long-term financial needs is invariably uncomfortable to live with through the journey, because of the ups and downs.
Next week, Greg and I look at why investors so often get it wrong…