Behavioural finance is a fascinating subject to study in relation to the markets. As they say, if you loose on the markets, it is not the markets that are losing, it is your behaviour that makes you loose.

The ancient Greek saying, know thyself, was the most important piece of education and advice that was handed out to young men. For, knowing yourself means understanding how you are likely to behave under various circumstances. And from there emerges preparedness. Because as behavioural finance theorists have told us often enough, half the battle lies in knowing your pitfalls. Once you know the traps you are likely to fall into, you can avoid them or at least allay them. What are the lessons from these in managing your finances?

Personality issues
We react in different ways to risk-averseness and decision making under stress. But we do not have the same pattern for risk behaviour; we exhibit anomalies or contrariness in our behaviour to risk. Exactly what the 2002 Noble Prize winning economist Daniel Kahneman researched. Daniel Kahneman and Amos Tversky called their studies of how people manage risk and uncertainty, the Prospect Theory. Kahneman and Tversky theory developed over a thirty year period, is however highly important in economics. Kahneman won the Nobel for investigating apparent anomalies and contradictions in human behaviour. Subjects when offered a choice formulated in one way might display risk-aversion, but when offered essentially the same choice formulated in a different way, might display risk-seeking behaviour. For example, as Kahneman says, people may drive across the town to save $5 on a $15 calculator but not drive across town to save $5 on a $125 coat. Tversky work demonstrates that people’s attitude toward risks concerning gains may be quite different from their attitudes toward risks concerning losses.

For example, when given a choice between getting $1000 with certainty and having a 50% chance of getting $2500, they may well choose the certain $1000 in preference to the uncertain chance of getting $2500. This is a type of risk-aversion behaviour that cautious investors display. But Kahneman and Tversky found that the same people when confronted with a certain loss of $1000 versus a 50 per cent chance of no loss or a $2500 loss, do often choose the risky alternative. This is classic risk seeking behaviour. This is not necessarily irrational but it is important for us to recognize the asymmetry of human choices.

Another experiment by Richard Thaler also throws light on this behaviour. The experiment in which students were told to assume they had just won $30 were offered a coin-flip upon which they would win or loose $9. Seventy percent of the students opted for the coin flip. When other students were offered $30 for certainty versus a coin flip in which they got either $21 or $39, a much smaller proportion, 43 per cent, opted for the coin flip. Isn’t it clear where you stand vis-à-vis risk towards loss or gain?

Some of the problems of interpreting human behaviour in the face of risk has to do with the problem of people making decisions on the basis of subjective assessments of probabilities which may be quite different from objective or true probabilities.

Events of small probability that have never occurred before may be assessed as having a probability of zero in decision making, but this leads to tragedies in which people find they have been playing Russian roulette without even knowing they are doing so. In fact, life is sometimes like Russian roulette on a large scale and the markets are only a small sector with great losses and opportunities.

Kahneman realized that small probabilities add up when chances are taken repeatedly. A notable phenomenon is what happens to the probability of avoiding a small risk event when the probability is increased. Even a doubling could change the picture entirely.

For example, suppose the probability of being involved in an accident on any one trip is 0.0001. In 2000 trips the probability of not being involved in an accident is about 0.82. If the probability of being involved in an accident is doubled to 0.0002, the probability of not being involved in an accident in 2000 trips falls to 0.67.

Some of the problems of interpreting human behaviour in the face of risk has to do with the problem of people making decisions on the basis of subjective assessments of these probabilities which may be quite different from objective or true probabilities. To the educated, trader personal psychology is the real difference between winning and losing. One of the many issues to examine within your personal psychology is your particular personality. The Meyers Briggs personality tests which companies routinely use to assess personality traits for leadership qualities is a useful tool for you as an investor. Can you sit quietly in a room while the world is going about selling and buying or do you need to be part of the herd? Do you want to lead and take a decision at any cost or does rationality rule your life?

Every time you loose money, think: your personality is losing you the money, not the market. Every time you mistime the market in your irrational exuberance or cut back just when you are on threshold of making a killing, it’s your self-sabotaging personality that is causing it. While it is perfectly respectable and normal to make mistakes initially, till you get a feel for trends, you need to watch out if you are making the same mistakes. How far ahead have you got in your learning curve? But what isn’t obvious is that your personality also determines what investing mistakes you are most likely to make.

Where do you fit in?
Actually, that was a key finding of a study done by research firm of Mathew Greenwald & Associates Inc. for Merrill Lynch Investment Managers. Merrill divided the investors into four distinct personality types. See if you can find a match for yours.

Measured investors are secure in their financial situation and confident they will have a comfortable retirement, Merrill Lynch said.

These investors are least likely to say they waited too long to start investing or that they haven’t invested enough. Moreover, they are least likely to be plagued by emotions such as fear and anxiety that commonly cause investment mistakes.

Reluctant investors don’t particularly enjoy investing and prefer to spend as little time as possible managing their holdings. Not surprisingly, that group was the most likely to have a financial adviser. They are least likely to become overly attached to an investment or to put too much money into a single holding.

Competitive investors enjoy investing, are informed and try to beat the market. They are most likely to have started investing early, to put enough money into their investments and to invest regularly. On the downside, their enthusiasm for investing can be their undoing. They have a hard time letting go of losing investments, often dedicate too much of their portfolio to one stock and tend to be greedy logging on frequently to hot stocks.

Last, there are unprepared investors, who have no control over their investment strategy. Lacking confidence, they are the kind who push the accelerator when they should be breaking. The survey involved 1,000 U.S. investors who had annual house-hold income of at least $75,000 and at least $75,000 in assets to invest.

Common errors
Some mistakes in investing commonly seen and those that need to be avoided are:

Over-confidence: Researchers have found that people consistently overrate their abilities, knowledge, and skill – especially in areas outside their expertise. So look for good advice from objective source.

Anchoring and adjusting: Did you know that in considering a decision, we often give disproportionate weight to the first information we receive, hence anchoring our subsequent thoughts? Imagine the wrong information and its consequences. Multiple info sources often mitigate this flaw.

Framing: The decisions of investors are affected by how a problem, or set of circumstances, is presented. Even the same problem framed in different, and objectively equal, ways can cause people to make different choices. Framing, too, plays a central role in assessing probabilities.

Irrational escalation of a commitment: Investors tend to make choices that justify past decisions, even when circumstances change. So only consider future costs and benefits.

Confirmation trap: We all fall into the trap of seeking out information that supports our existing point of view while avoiding information that contradicts our opinion.

You must also understand how you tend to react under stress. People with different personality profiles behave in dissimilar ways when stressed. Here again, self awareness and some basic techniques to offset sub-optimal behaviour go a long way. Here is what you can take away from here: small probabilities add up when chances are taken repeatedly. So take a test. A type of personality test worth examining is the Meyers Briggs instrument. This will give you a pointer to your risk averseness, gregariousness etc. that will give you indications of how your ego guides your financial decisions and other choices in life. Self introspection and seeking professional guidance will go a long way in managing your wealth better.