What is behavioural finance?

 

What is behavioural finance anyways? Sounds like overly complicated jargon, but it's actually an interesting subject of study that has come about over the last decade or so. Behavioural finance is the study of how people react to market conditions as a whole and how this reaction in turn effects the markets. It's the study of economic mob mentality and when it comes to your investment portfolio it can be an important factor.

Understanding the psychology of how we make financial decisions is critical for our long term financial health. We would like to believe that all our financial decisions are well thought out and calculated, adjusting for risk and maximizing the returns. In reality a lot of our decision making is irrational, driven by two main emotions. Fear and greed. Like a recovering alcoholic, the path to recovery is to acknowledge that you have a problem and take steps to mitigate the problem.

In Carl Richards' "The Behavior Gap", the topic of behavioural finance is discussed with emphasis on how understanding the role of money in one's life can lead to a healthier wealthier one. Here are three important lessons from this book:

1) There's a difference between investment return and investor return. Investment return is the amount your investments will earn over the lifetime of the investment, given that you do not make any adjustments to the investment. Investor return is the actual return you receive, which in most cases is lower. This is caused by jumping in and out of the investment as a result of the fear (when the markets perform poorly) and greed (vice versa). The difference is what Carl calls the behavior gap.

2) The more you make, the happier you'll be (only to a certain point). There is a point when extra income won't make you any happier. There was a recent study by Noble Prize winning economist Daniel Kahneman that showed there is little increase in happiness after earning more than about $75,000 a year. It's hard to quantitatively measure happiness, but the idea is that once your basic needs are met and you have some extra to travel and have a few perks, you may meet a plateau of happiness with earnings. Also, the extra earnings may not be worth the extra stress it comes with.

3) Financial plans are worthless. Since most are based on assumptions and try to extrapolate out to decades into the future, financial plans need to be flexible. Having an idea of where you want to be financial is good, however the idea of having a rigid financial plan is useless. Life has many unexpected bumps that can lead you way off course from your financial plan. Instead its best to have guiding principles that help you make financial decisions that are in line with your long term goals.

Here's a video where Carl explains the "Behavior Gap":

Looking for Passive Income?

The two main way to meet personal financial goals is to save more by cutting expenses. The other way is to increase your income. There are only so many hours in the day to work and quite frankly working every waking hour may not be much of a life at all. One way to increase your income is by increasing it passively through investments. One of the best sources of passive income is through dividend paying stocks.

In Charles Carlson's "Little Book of Big Dividends", he goes through the basics of investing in dividend paying stocks. Given that you already know how to go about purchasing stocks, this book focusing on the process in which to choose solid companies that will likely be safe and will continually pay you through dividends.

So what are some of these important criteria that a stock must meet in order for it to provide big safe dividends. One concern is the dividend payout ratio. When a company makes money through sales it has to subtract costs to obtain its earnings. These earnings (if the company is making money at all) can either be reinvested into the company or paid out to shareholders as dividends. The percentage of the earnings that is paid out as dividends is known as the dividend payout ratio. For instance, if a company earns 1 dollar per share in earnings and pays 50 cents at the end of the year per share, than the payout ratio is 50% (0.5 divided by 50).

Carlson says for the dividend to be safe the payout ratio should be no more than 60%. That way some of the earning is kept within the business to allow for its growth.

Another main consideration is if the company has a history of raising dividends over time. This is critical because growing dividends helps your income keep pace with the increased cost of living (known as inflation). An additional screen would be to find companies that have consistently grown there dividends over the years. Inflation averages out to be about 3 to 4% per year, so dividend growth that exceeds that would be optimal.

A final word of caution is not to chase exceedingly high dividend yields. A dividend yield is calculated by dividing the dividend by the stock price. Say the dividend per share is 10 cents a year and the stock is trading at 1 dollar share. In this case the dividend yield would be 10% (10 cents divided by 1 dollar). That's a pretty sweet yield. Chasing high yields is tempting, but it can also be a sign of trouble. It is difficult for companies to sustain high dividend yields, therefore exceedingly high yields could mean that there is going to be cut in dividends in the future or that the company is in dire financial trouble.Historically, safe dividend yields can range from 1-6%, anything greater should be investigated with caution.

For more information I would recommend borrowing this book from the library. It's a really quick read and gives you the basic foundation for dividend investing. Good luck and keep saving!

Why dividend stocks?