Behavioural finance is a social science that examines why people make impulsive decisions that can jeopardise their asset allocation and, ultimately, their wealth, such as buying expensive items, selling cheap, and doing a variety of other irrational activities. But by understanding our thought processes, we can enhance our decision-making, as well as how we protect and grow our wealth.
The Connection Between Asset Allocation And Behavioural Finance
We are all emotional beings and when under pressure we tend to approach situations with a fight or flight response. On the other hand, when things are going well, it is difficult to not get carried away. Our natural tendencies can prove detrimental when handling our own finances and may cause issues with asset allocation.
In fact, a whole field of social science called behavioural finance is dedicated to studying how frequently these natural responses are used in financial decisions and how frequently they turn out to be incorrect.
The Chartered Accountants’ trade organisation, who are well-versed in finance, provides the following definition of behavioural finance[i]:
“It attempts to explain how decision makers take financial decisions in real life, and why their decisions might not appear to be rational every time and, therefore, have unpredictable consequences. This is in contrast to many traditional theories which assume investors make rational decisions.”
Your asset allocation strategies could be flawed as a result of this irrationality.
What Is Asset Allocation?
This is the phrase we use when deciding how your money should be invested, including stocks, bonds, property, cash, and other assets. It also includes the allocation of the type of investments and their location, in others words, the ratio between UK and international investments, such as UK shares against foreign ones or government bonds versus corporate bonds.
However, it’s not just about where your money is invested; it’s also about how these assets balance risk and reward. It is how they counterbalance one another because if one part decreases, you need another to increase at the same time to make up for any losses.
As behavioural finance demonstrates, it can be simple to do it right but as simple to get it wrong.
Top Five Mistakes In Asset Allocation
People can become overconfident and think they can predict the future of the stock market, an investment, or the value of a home. 76% of professional fund managers who make decisions about strategic asset allocation for a living said that they were above average in their jobs in a 2006 survey.[ii] Their overconfidence may result in unneeded trades or poor judgement.
Your confirmation bias may make this error worse if you are certain that prices are rising. This entails concentrating on data that supports your argument and ignoring data that refutes it. The idea of evidence-based investing, where assets are allocated based on facts and empirical data, is at odds with this selectivity.
Different money pots can sometimes receive different treatment. We all definitely have a tendency to view windfalls and tax refunds as more ‘fun’ money because they are not usually anticipated. And we frequently have very different perspectives on our hard-earned cash. Regardless of your actual objectives, this mental bias can cause you to misallocate some of your wealth, investing windfalls in riskier assets and earned money in safer ones.
Loss Aversion Bias
Financial pleasure and pain are very distinct emotions and how we cope with each one varies dramatically. For example, people typically feel the the pain of losing the same amount of money much more than the joy of winning it. You may monitor and fiddle with your money too frequently as a result of this loss aversion bias, sometimes at the expense of long-term objectives.
Psychologists have found that people have a tendency to rely too heavily on the very first piece of information they learn, which can have a serious impact on the decision they end up making. In other words, if you believe something is worth £X, possibly because it first appeared to be a bargain at £X, then £X is the amount you would be willing to pay for it, regardless of new knowledge or if £X offers your total portfolio value.
How can you avoid these asset allocation mistakes?
- Setting a goal and determining the level of risk you can take will both be very beneficial. Then, you or your wealth manager can evaluate each choice you make in terms of how it relates to your goal and level of risk tolerance.
- Focusing on the long-term is also essential. It’s likely that you are making investments with fairly distant goals in mind, like retirement or setting aside money for dependents. Time is always on your side in this situation, but short-term tinkering and tampering are frequently the enemy.
- Changes might be necessary. Not those motivated by fear or greed. This includes sensible rebalancing of your asset allocation – say, a slightly higher proportion of bonds and less in shares to mitigate risk or for your portfolio to align to your own personal goals and financial targets.
- Lastly, the importance of sound professional financial advice cannot be emphasised enough. Financial planners have a thorough awareness of the research supporting investing, can assist you in setting sensible, attainable goals, and, if necessary, can gently question you on decisions you make in light of that research and your goals.
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iii. First Wealth