The Importance of Understanding Behavioural Finance

…or why does the average investor make such poor financial decisions?

Behavioural Finance, covering the rationality or otherwise of people making financial investment decisions, is a rapidly growing area of academic study.

Behavioural Finance covers “individual and group emotion, and behaviour in markets. The field brings together specialists in personality, social, cognitive and clinical psychology; psychiatry; organizational behaviour; accounting; marketing; sociology; anthropology; behavioural economics; finance and the multidisciplinary study of judgment and decision making”. (Source: Journal of Behavioral Finance)

For a general introduction to Behavioural Finance, click here.

For a more advanced view, read the Journal of Behavioral Finance.

The Boston-based research company Dalbar in its 2007 report “Quantitative Analysis of Investor Behaviour” found that in the past 20 years

• the American S&P 500 Index returned on average 11.8% pa
• the average investor earned 4.3% pa.

The main reasons for the variance were poor investor behaviour and the tendency for the average investor to sell after a stock price has fallen a long way and then buy back in to the market after it has already risen a large amount. Effectively the average investor is buying high and selling low. Not very smart!

Reflect on the Dalbar survey results above: if the average investor underperformed by a large margin, then who is outperforming? What techniques are these investors using… Food for thought!

Those who are cognizant of these behavioural factors are in a position to profit from the public’s foibles.

Archimedes Financial Planning closely follows this field of study, thereby benefiting its clients.