With the world still reeling from the 2008 financial crisis and further threats on the horizon, including a slow-down in China and tensions in the Eurozone, individuals and professional investors alike are looking for ways to make smarter investments.
But none of us are perfect and, try as we might, we can’t get away from the fact every choice we make has an emotional element. Even the most seasoned asset manager will be making decisions that aren’t solely driven by rational thinking.
For more than 25 years, Behavioural Finance experts have successfully employed knowledge from psychology, sociology and even physics to help unlock the secrets to our financial decision making. At the same time, advances in technology have allowed neuroscientist to map the chemical and electrical processes that happen in our brain when we make choices.Both are now combined in the emerging field of Neurofinance. And it’s proving to be a powerful tool in understanding investment behavior.
Here are just three ways it is changing the game
1. Less choice makes for better investments
If you have to make snap decisions in a volatile, uncertain and complex environment, there is compelling evidence focusing on just a few stocks can improve investment performance. While diversification may have been the name of the game in the past, at a neurological level a vast array of real-time analysis and information make it easy to succumb to choice overload. At its worst, this can lead investors to rash decisions based on current market sentiment.
A smaller, focused portfolio is easier to manage and should lead to better returns over time. So it makes sense to keep it simple and play the long game.
2. Don’t get attached to names
We all have a natural tendency to ‘anchor’ to names and numbers. Even the most seemingly innocuous information can find its way into our subconscious.
Research has shown that familiar brands trigger different patterns of activity in our brains, which can have an emotional influence on our decisions. If you pass three Apple stores during your daily commute, chances are you’ll be subconsciously driven to change your investment behaviour to Apple stock. By labelling stocks A, B, C instead you can drive out unconscious biases and eliminate emotion from the process.
3. Forget about purchase prices
We’re hard-wired to feel the pain of loss more than we experience the joy of gaining. MRI scans of people’s brains have shown losses trigger far greater activity in areas associated with negative emotions than equivalent gains set of in our pleasure centres.
Some leading figures in the international investment community, including AthenaInvest’s Dr. Tom Howard now advocate ‘forgetting’ the price paid for stocks to eliminate loss aversion. If you’re in it for the long haul you can save yourself a lot of emotional discomfort, unnecessary stress and avoid any rash judgments caused by short-term market volatility.
Dr Arman Eshragi is a Course Organiser for Investment, Securities and Psychology of Finance. This article, written in conjunction with Dr Adam Moore, was originally published on University of Edinburgh Business School Insight (10 March 2016).
Image credit: Headcase by John M. CC BY-SA 2.0