Becoming a Rational Investor

Most economic theory is based on a world full of informed, iron-willed people who always make rational decisions. Behavioural finance, on the other hand, recognises the obvious: investors are often influenced by emotion, and therefore they sometimes risk making illogical, inconsistent and ill-informed decisions, despite their best intentions to act in their own self-interest.

There have been many studies in behavioural finance since the field took off 30 years ago. The studies have attempted to find out how most people really act when making financial decisions. It turns out that we humans have several tendencies that don’t help much when we are investing. Here are some of the most common traits that can cause problems for investors:

• Failing to take on enough risk, and thus investing too conservatively. Over many years, the most conservative investments (such as cash and bonds) do not keep up with inflation. Thus, ironically, what seems most conservative actually bears more risk: the loss of purchasing power to inflation as the years pass by.
  
  
• Selling winners too soon (to lock in profits, thus creating a feeling of victory), but holding losers too long (waiting for them to get back to even so that there is no loss to regret).
  
  
• Forgetting that the real goal of investing is to build wealth as effectively as possible, rather than to justify the decisions you’ve made that got you where you are right now. This can lead you to fail to evaluate your current investments on their potential to produce gains from this point forward.
  
  
• Decision-making becoming paralysed by too many options. This inability to make ‘choice under conflict’ leads to taking no action at all when action is called for.
  
  
• ‘Preferential bias’: The difficulty in changing an opinion about something once an opinion has been formed, even if the opinion is only subconscious. This causes incoming information to be processed selectively, with supportive information being favoured and contradictory information downplayed or even ignored. The end result is reduced objectivity.

Obviously, an investor who is subject to any or all of these traits cannot be totally rational, even if they are trying very hard. This is where a professional adviser can assist, by providing tools and processes that can help people counteract some of our psychological tendencies. Most importantly, an adviser can offer objectivity by:

• Providing a thorough system for evaluating whether an investment is suitable for you.
  
  
• Helping you ensure you don’t make snap judgements based on fragments of information or ‘hot tips’.
  
  
• Writing out your financial and investment goals.
  
  
• Taking into account your unique situation, including honestly assessing your appetite for risk and for volatility in your holdings.
  
  
• Choosing strategies that are more likely to help achieve your goals without making you uncomfortable then helping you stick to those strategies.
  
  
• Systematically reviewing your holdings with an eye to the future.

In uncertain times like these, it’s easy to fall into the trap of making hasty decisions. Please feel free to contact your adviser if you have any concerns about your investment portfolio and what you have been reading in the media. They can help you put these developments into perspective.