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If markets are efficient, us humans are not.

We humans are hardwired to respond to stimuli, and correctly so – it is how we survive. But when it comes to investing this trait can be a pitfall. Sitting staring at a screen of flashing lights, seeing portfolio values rise and fall daily, reading the financial news (or worse, watching financial TV) all feed our craving for stimulation and spur our actions.

The feeling of being up to date on something is fantastic, and is reinforced by the media as being a must-have if you are to succeed. It, coincidentally, generates traffic to websites/apps and posts on social media, run by businesses that want advertising revenue. In reality, most of this news is just ‘noise’ – inconsequential to long-term returns and best ignored. Reducing the impact on our investment decisions can, however, be tricky and requires a little more thought than simply burying our head in the sand. After all, we need to be listening for the ‘signal’ that risk reward is in our favour.

If we think about what we might constitute noise, something like a news headline that gains lots of attention or a company that is frequently discussed on social media, the common theme is that the actual informational content is low and could be inconsistent in nature (possibly even biased). So, we can probably say it has no place in a decision making process (should we buy something just because someone tells us we should?). Signal, on the other hand, could be considered something slow moving, consistent, and from data sources that we may deem credible, such as population growth or prospective returns available on an investment relative to how it may behave. These could be critical points in making a good investment decision and can be monitored with relative certainty or ease.

Looking out for the signal is one thing, being in a position to process that signal well, and make a decision, is another matter.

Over the last half century, the practice of behavioural economics has emerged to challenge traditional economic theory; most significantly the notion that all economic actors (people, firms, governments etc.) are rational in their decision making. The seminal 1979 work by Daniel Kahneman and Amos Tversky by the name of Prospect Theory explored how individuals respond differently to gains and losses on their investments. Today behavioural economics is a very wide field of study that tries to explain why we make decisions and how we can improve them.

The process of improvement is by no means the pursuit of perfection (we will all make mistakes) however being aware of issues can move us closer to achieving the right outcomes. We now know that we are likely to put too much emphasis on something we have recently read (recency bias), seek out data and opinions that align with our thinking (confirmation bias), and have overconfidence in our abilities and avoid making a decision due to fear of regret (regret-aversion).

Being aware of all this, and how it affects both individuals and groups of people, is a starting point to an efficient investment process.


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