The financial sector is turning to psychology to help understand why investors make the decisions they do and attempt to improve outcomes using behavioural finance.

Paul Kaplan, research director at Morningstar Canada, says: “The insights of behavioural finance are not just for academics to debate. They have important implications for investors. By understanding the systematic cognitive errors that we tend to make, we can manage them and become better investors. This is what financial advisers who provide behavioural coaching help their clients do.”

Advocates of behavioural finance have identified numerous drivers of irrational investment decision making, which range from over- and under-confidence, to information overload and lack of knowledge. These can largely be condensed into six areas:

1. Following the herd. Safety in numbers is usually a truism, but when it comes to investment, following the crowd is not always wise. Herding can see investors buying at the top and selling at the bottom. Financial advisers can help by reminding clients to invest according to their goals rather than following the latest trends.
2. Loss aversion. While jumping ship too early can cost investors dear, so too can hanging on to the wreckage for too long. Investors are prone to selling early when things are on the up and failing to sell when they should, in the hope conditions will improve. Advisers need to help investors make sense of why assets are behaving in certain ways and make decisions based on knowledge, not emotion.
3. Anxiety. Too much short-term information and alarming headlines make investors jumpy. Advisers need to encourage investors to take a long-term view and resist the urge to make knee-jerk decisions.
4. Over-optimism. While it is good to have a positive outlook, assuming markets will always carry on in an upwards trajectory is not wise. Advisers need to help clients build a diversified portfolio of assets that can insulate against downturns.
5. Over confidence. Just because an investor has been successful in the past does not mean the experience will be repeated. Advisers need to be on hand to explain risks and keep clients’ feet on the ground.
6. Projection. Getting stuck in the here and now can prevent investors from seeing how their goals and objectives have shifted. Advisers should keep portfolios on track and ensure investments are still suitable to changing lifestyles.

Humans are certainly not infallible, but behavioural finance has helped advisers understand where investors are likely to make mistakes. Taking time to understand personality types and risk appetites can make all the difference between investment success and failure.