The behaviour of everyday investors boosts the unpredictability of financial markets—but that behaviour isn’t necessarily irrational. The word normal might be a better fit, according to Meir Statman, PhD, a behavioural economist at Santa Clara University in California and a leader in the field of behavioural finance, which merges finance and psychology.
In his new book, Finance for Normal People: How Investors and Markets Behave, Professor Statman dismisses the popular idea that investors should set aside their emotions. By embracing their emotions, he argues, they can learn from their mistakes. His book is a follow-up of sorts to his 2011 one, What Investors Really Want, and it builds on work he has published on the topic in numerous research papers and articles.
Emotion has its place
As the field of behavioural finance has evolved, so has the lens its practitioners use to view investor behaviour.
“In the early days, we talked too much about people who are irrational and too little about people who are just normal—and usually normal is smart,” Professor Statman told Vanguard. “If we recognize the errors we make, we can overcome those errors, both cognitive and emotional.”
Emotions can play both positive and negative roles in investors’ decisions.
“It’s very common, when people talk about behavioural finance, to think of emotions as a synonym for emotional errors,” he said. “But the usual advice to set emotions aside when you invest is neither feasible nor wise. Fear is a very useful emotion. When people fall for scams, it is because they did not fear enough.
“Emotions are usually good teachers. For example, regret over a mistake we’ve made teaches us not to make it again. But emotions can sometimes mislead us. If you invest in stocks and the market goes down, you’ll feel regret, but you’ll need to pause and ask yourself whether you truly made a mistake. Just because the market went down doesn’t mean you should dump all your stocks.”
Control what you can
In Canada and other countries, equities have surged since the 2016 United States presidential election, defying analysts’ initial expectations. That surge, Professor Statman said, offers investors a lesson on the perils of hindsight.
“Hindsight can be useful, and it can also be dangerous,” he said. “I don’t tell myself that I knew the market would go up, because, in truth, I did not know. And I don’t know where the market is going next. I keep my portfolio allocation steady according to the risk I can sustain, and I don’t try to predict what the market will do next.”
Behavioural finance can be useful in creating a long-term investment plan. Determining one’s goals is the first step.
“It comes back to ‘what it is you want,'” Professor Statman said.
“Set the allocation of equities, bonds and other investments so that you have a portfolio balance that’s consistent with the balance of your goals. And make sure you’re knowledgeable about investments and markets”
To that we might add this: Make sure you’re knowledgeable about yourself, too.