The human factor
Investors are not always as rational as they presume, but behavioural finance can help them identify and address their biases.
Paul Craven, a member of the Magic Circle, sees no incongruity in combining a career advising financial institutions with his love of performing magic. The common link is psychology. Having worked for top financial firms, he now advises the sector on behavioural finance or, in layman’s terms, on avoiding some of the psychological pitfalls that lead to poor decision-making.
“Magic can deceive us by exploiting the mental shortcuts that we all rely on to navigate ordinary life.,” says Craven. “The successful transfer of your DNA over hundreds of thousands of years is testimony to how effective and necessary those shortcuts were to your ancestors. But they also lead to heuristics and biases – a tendency to behave in a certain way – which may not be appropriate in environments like financial markets. Ultimately, they can lead us as investors into poor investment decisions.”
Most of us will recognise the patterns of flawed decision-making. One is defaulting to a ‘do nothing’ approach. Equally widespread is the tendency to follow the herd and thus sell at the wrong time in an investment cycle.
Theoretical economists’ long-held – but simplistic – assumption used to be that investors always behave rationally so as to maximise returns.1 Behavioural scientists have since cast that view aside and instead identified a clutch of behavioural biases that are embedded in our decision-making processes.
Among the most frequent is loss aversion. As investors, we are more sensitive to the fear of losses than we are to the potential for gains. Studies suggest that people weigh losses more than twice as heavily as gains.2 Indeed, the idea of a loss can be so painful that people tend to delay recognising it until forced to. That same fear can also lead ordinary investors to sell a profitable share too quickly.
Another recognisable problem comes from relying too heavily on the first piece of information we receive, and turning it into an arbitrary reference point – known among psychologists as ‘anchoring’.3 This is one reason that sales work so well – consumers are captivated by the slashing of the headline price.
But what is the actual impact of these biases on financial returns? In its latest annual report, DALBAR – a Boston-based financial services research company – suggests the behavioural biases of investors are likely to have a negative impact on returns. Thus, some investors succumb to short-term strategies such as market timing, the belief that you can anticipate moves in markets, instead of exercising the discipline necessary to capture the market’s longer-term benefits. Data from the US shows that the average investor achieved just 60% of the return provided by the broader market in 2016 due to poor market-timing decisions. DALBAR argues that we are probably our own worst enemy when it comes to making investment decisions.4
Professional fund managers have one significant advantage – they are trained to understand the impact of biases and can attempt to mitigate the risks. Much of Craven’s work with investment professionals is to get them to avoid ‘groupthink’ (as many decisions are made by committees); and to analyse what could go wrong with a decision, rather than devoting time to finding evidence that supports a decision they have already made. “Although it sounds straightforward, countering behavioural biases proves not to be as easy as people imagine,” he says. “People appear not to learn from past experience.”
So, what are the practical lessons? Investing tends to require a long-term strategy, so it is crucial to try to avoid allowing behavioural biases to influence your decision-making, particularly in the short term. Focusing on your long-term financial goals and the reasons why you invested in the first place is far more productive.
As ever in investing, it is not the journey but the destination that matters.
1 investopedia.com, August 2017
2 James Montier, Behavioural Finance, 2002
3 psychcentral.com, August 2017
4 ifa.com May 2017