Until very recently, most economists believed in the "efficient market hypothesis" that people always behave in a financially rational way, causing the price of shares (and other assets) perfectly to reflect all available information. Yet at best, the theory is a simplification. At worst, it is nonsense. A growing number of studies show that human psychology which is far from financially rational affects investment behaviour, leading to the emergence of a new subject, "behavioural finance".
One major factor is "herding". As far back as 1896, French psychologist Gustave Le Bon noticed that people in groups tend to copy other group members, even if the facts suggest that's not a good idea. This might be rational if the people being copied have unique information, but this herding instinct is also what fuels market bubbles and crashes. The dotcom frenzy of the late 1990s is just one recent example.
Investors also tend to be overly confident in their stock-picking abilities and their potential returns, which encourages them to trade too often. One well-known study from 2000 by Brad Barber and Terrance Odean of the University of California found that the most active retail investors manage to make slightly higher gross returns than the least active but after costs and fees, they did far worse.
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There is also plenty of evidence that the market overreacts to minor events. In 1981, Nobel laureate Robert Shiller compared the volatility of stock prices to actual changes in earnings and dividends. In theory, they should be equally volatile in a perfectly efficient market, share prices should reflect profit expectations, which in turn are driven by earnings and dividend payouts but in practice stock prices were five to 13 times more volatile, suggesting that a lot of the market's volatility is irrational, with no real basis in the underlying reality.
But perhaps most telling was a 1988 study by David Cutler, James Poterba and Lawrence Summers, which found there was no difference between price movements on days where there was a lot of news (and thus lots of fresh information being added to the market) and days when there were few news releases. Below, we look at five ways in which behavioural finance can teach you to be a better investor.
Five tips from behavioural finance
2. Avoid popular stocks: the herding instinct encourages investors to pile into stocks that have done well, driving up prices. There is evidence that following momentum can work in the short term, but longer term returns are less flattering. In 1985 Werner De Bondt of DePaul University and Richard Thaler found that buying shares that had done badly and holding them for long periods significantly outperforms the market. Others have found that stocks with high price/earnings ratios do worse than those trading at low earning multiples (see cover story).
3. Rebalance your portfolio: one way to avoid herding is regularly to rebalance your portfolio, to ensure that no single investment becomes too dominant. That automatically reduces your exposure to assets that have surged in price. A 2010 study by Vanguard found that annual rebalancing to maintain a 60:40 split between stocks and bonds significantly cut volatility.
4. Invest regularly: one way to curb the tendency to overreact to short-term news is to use "pound cost averaging" setting aside a fixed amount to invest each month, so if the stockmarket falls, you end up buying more shares. This regular savings strategy also helps you to avoid all the pitfalls associated with attempting to time the market.
5. Read a wide range of sources: we all suffer from confirmation bias, the tendency to pay attention only to information that confirms your world-view. So make sure you counteract that by reading a wide range of material including reports that contradict your opinions rather than relying on one source.
