6.2 Behaviour and risk
In this final week of Managing my investments you will take a slightly different angle on the consideration of investment risk and risk management from the approach that has been adopted so far in this course.
During this week you will consider the human behavioural aspects of investment decision making and appetite for risk – aspects of investment decision-making that are often neglected. This may be due to such behavioural aspects not being considered relevant by investment managers. Additionally such factors do not fit neatly with a perception that investment management is a largely quantitative subject where decisions are made in an un-emotive manner.
So this week will examine the risks that arise from human behaviour. You will look at how changes in the environment people work within can trigger changes in their behaviour and at how these changes may impact on the processes of investment management.
You will explore some of the research into behavioural finance. This has provided a framework to enable us to understand the often unappreciated behavioural influences on decision making. In particular we will examine how environments of uncertainty and risk generate behavioural biases that affect decision making.
You will examine the risks posed by individual biases – including ‘prospect theory’, ‘overconfidence’ and ‘anchoring’. You will also explore the impact of group behavioural biases such as ‘contagion’, ‘herd behaviour’ and ‘groupthink’. You will also examine how we can attempt to overcome these challenges by building awareness of the influence and consequences of these biases.
As you have seen during this course, the approach to financial decision-making is commonly from a quantitative perspective world. The tools and strategies that are commonly used to manage investment risk are mechanistic. It is therefore easy to have a perception that all risks are quantifiable. Similarly, it is tempting to believe that modern risk management techniques are efficient in their ability to identify and measure current and future potential risks.
There is no doubt that the ability to quantify risk in this way is an extremely valuable tool for those tasked with managing and monitoring risk. However, there is a danger that factors that affect investment decisions that cannot be measured in this way, like behavioural biases, are overlooked or dismissed.