When you’re trying to build a profitable share portfolio there are many ways you can come unstuck. One of the big hurdles is controlling your emotions so you protect the value of your portfolio and don’t engage in impulsive buying and selling.
What many people don’t realise is the big role psychology has to play here and that’s where behavioural economics comes in. This field of study shines a light on the cognitive biases we have and the role they can play in stopping us from investing to the best of our ability.
Investing through a behavioural lens
Simply put, behavioural economics, unlike classical economics, posits that people aren’t always rational and that there are neurological biases that influence our decisions.
When it comes to investing, insights from behavioural economics show that how smart you are with money, how much knowledge you have and how well you understand the market, is just part of the answer to building a robust portfolio.
That’s because it’s also critical, according to behavioural economists, to be aware of -- and manage -- the many in-built cognitive biases that can stop you reaching financial goals.
Anchoring bias
Some may say that one of the big tricks when it comes to dealing with cognitive biases is investing in companies with solid fundamentals, not just picking stocks.
This is one of the pillars of value investing -- creating for yourself a solid intellectual framework for making decisions and then forging the ability to keep emotions in check.
That’s where overcoming anchoring bias is so important. This is a cognitive bias that describes the tendency of people to rely too heavily one a single piece of information, like a stock price or movement in a share, when making decisions.
The problem with this approach is that it leaves you vulnerable if the underlying health of the company is at risk, but not reflected in the current stock price.
Indeed, there are a lot of fads out there when it comes to the next hot stock to get into. But the core philosophy of value investing is to hold shares in companies that have robust fundamentals, good management, are well established, and are easy to understand.
For this reason, value investors tend to like blue-chip stocks of established companies that have proven to be consistently profitable over a substantial period of time.
Think of it like this: value investing suggests an approach that thinks of buying stock as becoming an owner of the business, which means you want to know how a company operates, where it fits within its industry, who are its competitors, its long-term prospects and whether it brings something new to your portfolio.
So, it’s advisable before jumping into investing, to do your due diligence. A great source of information is a company’s annual reports, which contains future prospects, profit or loss, corporate strategy and core business activities.
Other ways to find out the health of a company includes looking at company alerts, prospectuses, and research reports which can often be accessed via share brokers.
Comparing companies in the same industry is also important, with popular methods including earnings per share, price earnings ratios and dividend yield. However, as a newbie investor you should also be aware that these are very simple comparison methods versus the highly-complex and time-intensive methods employed by professionals in the field. Professional investors can take months to determine whether a share is worth buying.
Remember whether you’re investing a large sum of money or just starting out always consider your options carefully and make sure to get financial advice before entering the market.
