The study of behavioural finance has developed over the past 30 years or so. It looks at the psychology and emotional factors behind making investment decisions and, by using these, identifies mismatches between how investors are assumed to behave, based on traditional finance theories, and how they actually behave in practice.
An understanding of these factors can help financial planners understand how investors make investment decisions, and the actions that may need to be taken to help investors make better decisions so as to avoid some of the common pitfalls of investment.
The traditional finance theories, such as modern portfolio theory (MPT) and the capital asset pricing model (CAPM), are based on many assumptions, which include:
- investors always behave rationally
- investors do not base decisions on factors other than risk and return only
- all investors have the same information available and will all use it in the same way (CAPM)
- investors are well-informed
- information is available at negligible cost
- investors understand all of the information that is presented to them.
From the above, it is already possible to see some divergence from real life!
While this paper is intended to serve as a summary of the main general principles underlying behavioural finance, there have been a multitude of papers and books written that study the subject in more detail. The intention of this paper is to provide financial planners with a basic understanding of the biases and other factors that influence investors’ thought processes. Planners can then begin to develop and implement strategies to influence investors’ behaviour to prevent them making some of the more common mistakes and to develop sound communication with clients to help develop trust.
An edited version of this research was originally published in the Q3 2017 print edition of The Review. The print edition is available to all members who opt in to receive it, except student members. All eligible members who would like to receive future editions in the post should log in to MyCISI, click on My Account/Communications and set their preference to 'Yes'.
Read the full paper – IFP Fellows' briefing paper: Behavioural finance