What is behavioural economics? An Introduction

Behavioural economics theory explains why investors can sometimes act against their own best interests. Putting into action rational, instead of irrational, behavioural economics can make a positive difference, says Greg Davies of Oxford Risk. 

Knowing how we should behave as investors is one thing, but our minds and instincts can actively work against our best interests. History suggests investors are prone to all kinds of wealth-destroying behaviour: falling prey to fads, panic-selling at times of crisis, excessive caution and wild optimism. Behavioural economics brings together psychology and economics to help understand and explain why investors behave the way they do as well as how to overcome those traits.

The understanding of behavioural economics has grown considerably in recent years. It is now well-recognised that humans tend to cling to what they know, rather than looking at investments objectively. Investors make snap decisions based on limited information; are generally unwilling to admit their mistakes and are disproportionately affected by the past performance of a specific investment.

In fact, academics have now identified over one hundred behavioural traits that influence the way people invest – from the ‘person with a hammer’ effect (where every problem is a nail) to ‘age-related positivity’ (where older people remember more positive than negative information). The problem is, says Greg Davies, head of behavioural science at Oxford Risk, it hasn’t noticeably changed market behaviour. As a whole, markets remain subject to these irrational behavioural forces.

He points out that the instinct for humans to herd together has been firmly established since Charles Mackay’s 1841 book ‘Popular Delusions and The Madness of Crowds’. This identified a variety of previous financial market bubbles, when investors had been encouraged to abandon their good judgment by the actions of the crowd. He adds: “The market has not learned a great deal in 180 years.”

These biases continue to make investors poorer. Year after year, the well-respected Dalbar study has shown investors’ returns are lower than those of the broader market because they tend to move in and out at the wrong moment. In 2021, for example, the study found that the average equity fund investor earned more than 10% less than the S&P 500 (18.39% vs. 28.71%).

However, even if it can’t change the patterns of markets as a whole, an understanding of behavioural economics can still have a vital role for individual investors. For this, says Davies, it is important for people to understand their investing personality. He says: “There may now be too many labels. Too many of them overlap or even contradict each other. Equally, they can be inconsistent, working in some environments and not in others. Perhaps most importantly, people display different characteristics to various degrees and react differently to circumstances.”

A key financial difference between individuals, for example, is composure. Davies says some investors are “energetically engaged” with the short-term movement of financial markets. “These people have very low composure and are troubled by the slightest bump. Those with high composure can be difficult to engage with their savings and be rather blasé.”

He draws a parallel between financial and emotional liquidity: “There is the famous saying ‘the market can stay irrational longer than you can stay solvent’ – the implication is that the investor has failed because their time horizon has hit zero. In reality, most people who sell don’t sell because they have to, but because they have run out of emotional liquidity. In general, their emotional time horizon is shorter than their actual time horizon.”

Oxford Risk has built a system that can help analyse an individual’s financial personality that is used by financial adviser groups and financial institutions. For investors looking to make better decisions, an understanding of their past behaviour is vitally important. This isn’t always easy to do because of another psychological bias – hindsight bias.

Davies says: “It is difficult to accurately recall why we have made a decision. If, in two- or three-years’ time, a decision turns out to be good, we overwrite our own meaning on it. If it goes badly, we say that we always had our doubts. We analyse our decisions to make ourselves look better.”

With this in mind, investors need to find techniques to make a robust analysis of their past decisions. Davies suggests decision-journaling. This looks at the reason for the decision, the degree of confidence, the investor’s emotions when the decision was made and the information they had to hand. The aim is to establish whether good decisions were prescient or simply lucky. Over time, investors can build a more robust picture of the reasons for their good and bad decisions.

This is a technique increasingly used by professional fund managers to help improve their returns. Davies says: “It’s like an elite sports team where they are monitoring movement, sleep, metabolism to see what helps improve performance in an objective and unbiased way.” 

Making good financial and investment decisions is not easy and our instincts can let us down. Better decision-making requires an honest appraisal of previous decision-making, rather than simply congratulating ourselves on the decisions that have gone well. Building these techniques into an investment strategy can help shift the balance between good and bad decisions, which should help your long-term wealth. Fineco’s reliable platform offers access to a broad range of investment options for serious investors.