Behavioural finance, in my view, is one of the most interesting and thought provoking areas of economics. Instead of focussing on the ways humans, or "Homo economicus", should behave in relation to their decisions, as traditional economic theory does, behavioural finance attempts to explain exactly why we as investors decide to make the choices we do. Choices which often don't seem to make any sense.
For example, the emotionless, disciplined investor assumed under traditional theories would analyse a stock rationally and objectively, not letting emotions sway their investment decisions. But in the real world a whole rangeofbiasesandfeelingscanaffect how we look at our investments and what decisions are made.
To give one example, confirmation bias is an affliction whereby investors only focus on factors which meet their pre-conceived positive beliefs and whereby negative factors are played down. But downplaying the negative aspects could be incredibly damaging to wealth. Take HMV in the early 2000s for example. Many investors were focussing on the company's strong market position and ignoring the ever growing rise of internet based music distribution. And we all know what happened to HMV. If you don't, here is a chart.
No matter how emotionless or regimented investors may be, these so called behavioural biases are still likely to affect their decisions at one time or another – after all, we are all human and not robots. In fact, an estimated 117 such biases have been identified by proponents of behavioural finance as being likely to sway decision making for the worse. These range from the well known overconfidence bias to the more exotic Semmelweis reflex.
Unfortunately, the discipline as a whole has been more concerned with identifying these biases rather than coming up with a practical solution to avoiding them – a bit like a doctor diagnosing a condition and not offering any treatment. It is in The Laws of Wealth that author Dr Daniel Crosby, attempts to take the discipline a step further, by analys- ing the theory behind investment psychology and then suggesting ways to become a better investor.
Crosby himself is an asset manager and founder of Nocturne Capital, has a PhD in clinical psychology and is a leading behavioural finance expert who uses his expertise in designing financial products and in security selection. He is also a prolific writer having authored books, newspaper columns and many blogs.
Setting the scene, Crosby begins the book by explaining that humans must invest in risky assets in order to survive and prosper over the long term. Given that inflation eats into wealth over time, no one will have a decent pension pot if they only invest in low risk government bonds and bank deposits. However, due to the way our brains are hard-wired we are ill equipped to invest in risky assets. This is because the world of investment often operates in contrast to everyday life.
For example, in investment, asset returns can often be predicted more accurately over the long term than in the short term. In contrast, you are probably more likely to know what you will be doing at this time tomorrow than in five years. And while in life the consensus view of how good a film is might be accurate, in investing the consensus view is often wrong – investment outflows being their highest at the bottom of the market being one example. So in a world which often makes little sense, clear rules must be applied if investors are to thrive.
DON'T BE SILLY
Part One of the book moves onto Crosby's key Laws of Wealth, ten rules of behavioural self management which must be digested and acted upon if investors want to increase wealth over their lives. The first rule, "You Control What Matters Most", reflects one of the main points of Crosby's overall work, being that investors can be their own worst enemy. He surmises that bad behaviour, or in other words, emotional responses to market conditions, can result in investors underperforming the market by up to 4.3% per annum. The next nine rules will help you to learn good behaviour and to close that bad behaviour gap.
What follows is some pretty good advice, including hiring a financial advisor specialising in managing behaviour, buying shares in bear markets and diversifying across a range of asset classes. All are explained in an entertaining manner but also backed up by theory and real life examples. In conclusion to each law Crosby provides a useful "What now?" summary section, which covers what to think, ask and do when faced with each situation.
My own particular favourite law is number four – "If You're Excited, It's a Bad Idea". In other words, investors should not let powerful emotions influence their decision making. While they have a huge part to play in life, Crosby suggests, "Emotions are the enemy of good investment decisions". We have all seen spurious marketing communications along the lines of "this stock will soar by 1,000%" and "live the life you've always wanted by investing in ostrich farms" and so on. The problem is that much of the investment world is controlled by marketers (not analysts) who are paid to put you into a state of excitement so that you will buy their products. After reading this chapter hopefully you will think twice before parting with your cash. In that vein, the author provides some useful tips on how to manage emotions, including exercising vigorously and limiting intake of alcohol – two things many of my investment chums will not be pleased about!
Part Two then goes on to introduce Crosby's Rules Based Investing approach, a set of factors which if successfully implemented will help to mitigate risk, exploit mispricing, protect from disaster and increase returns. He summarises his approach well with the following, "Exceptional investing over a lifetime cannot be predicated on luck. It must be grounded in a systematic approach that is applied in good times and bad and is never abandoned just because what is popular in the moment may not conform to longer-term best practices." This part will teach you those practices.
Crosby has two hopes for The Laws of Wealth. Firstly that it will make you better off financially and secondly that it will leave you with a richer awareness of self. While the first aspect may well come in time I have certainly become a lot more aware of my own behavioural biases by reading this book and intend to do something about them by applying the techniques described.
Overall, this is a highly readable book, well researched by an expert in his field and full of practical advice on how you can improve your long-term finances. Those who dislike equations and investment formulas will be pleased to see that the book is maths light, with any numbers presented in easy to read tables and charts. Interspersed with anecdotes and stories it is also an entertaining read. The Laws of Wealth will appeal to a broad range of investors including private individuals who are managing their own portfolio, financial advisors who want to provide exceptional service to their clients and fund managers looking for an edge in the markets.