There are all sorts of factors that impact on the returns that investors receive, but perhaps the most important is the human factor.
The problem is that, although markets are generally quite efficient, investors typically act in an irrational manner.
This video features Tim Richards, who is the author of the Psy-Fi Blog and an expert in how investors behave.
“The way that they behave, particularly the presence of money, isn’t what anybody would expect. It’s irrational because people behave in ways that mean that they lose money, and you can predict that they’ll lose money because of the way that they’re actually behaving”.
Why is it important for investors to have at least a basic grasp of behavioural finance?
The answer is simple, bad behaviour is extremely expensive.
Some studies have shown three to four percent a year is being dropped by investors purely because of making poor buying and selling decisions. Now that’s just one bias, that’s just one type of issue that they’re facing.
You know if people are consistently making mistakes in terms of when they buy and when they sell stocks. Over a lifetime that’s thousands, hundreds of thousands, millions of dollars.
Investors need to be aware of the different behavioural biases that exist, they also need to realise that they themselves are prone to them.
There’s a fundamental issue called the blind spot bias, which means that although people will acknowledge that biases apply to other people, they find it very difficult to accept it also applies to them.
According to Tim Richards, the best defence against behavioural bias is a passive investment strategy.
Which means buying a very broad range of assets and holding them for the long term.
There’s also a vast swathe of people who probably shouldn’t invest actively. And then I think at the extreme end there are certain people with certain psychological traits, particularly people who can isolate themselves from emotions, who can be effective active investors.
Of course, passive investors are not immune to acting irrationally.
For instance, you need to resist the temptation to bail out when markets are falling sharply. But recognising your biases and having an adviser who understands them too, gives you a big advantage.