These foolish things…
As investors, we have to contend not only with the erratic and unpredictable nature of markets but also the erratic and irrational way in which we think and behave.
‘‘If I have learned anything in my 52 years in this marvellous field, it is that, for a given individual or institution, the emotions of investing have destroyed far more potential investment returns than the economics of investing have ever dreamed of destroying.”
John C. Bogle, founder of the Vanguard Group
All investors have the best of intentions when making decisions (why would you not?) but our perfectly natural human behavioural biases can lead to errors in making decisions that can turn out to be very costly. Some of the common behavioural traps, and some tips on how to avoid them, are set out below:
I’m sure you’re thinking right now that these don’t apply to you, which is exactly why you need to read this blog!
- Trap 1: Believing you are better than average
Human beings tend to be overconfident in their abilities; evidenced by studies which show that 80% of us think we are better than average drivers. In a recent survey of 600 professional fund managers almost three quarters said they were better than average.
Mitigation strategy: Have some humility – plenty of very clever people get beaten-up by the markets and there have been some great examples of this in the last 12 months due to BREXIT and the US election results.
- Trap 2: Mistaking random noise for patterns
A rational gambler playing roulette knows that the chance of any number coming up is the same as any other number. Yet, a sequence of three red ‘9s’ in a row, can create quite a stir at the table.
Mitigation strategy: If you think you have detected a pattern in shorter-term data it is probably meaningless.
- Trap 3: Problems with probability (and maths in general)
For example, many people are willing to pay more for something that improves the probability from 95% to 99% than from 45% to 49%, despite the financial benefit being the same. Virtually no one can compound in their heads.
Mitigation strategy: Do not ignore the maths. Sit down and spend a little time teasing out the numbers.
- Trap 4: The Monday morning quarter-back – hindsight delusion
With hindsight we often honestly think we could have predicted what has happened, such as a fall in the markets. The evidence suggests that we cannot.
Mitigation strategy: Remember at all times that the future is unknown and unknowable, nobody has a crystal ball.
- Trap 5: I will throw my anchor out here thanks
The human mind really likes to use mental ‘anchors’ when forming opinions, which in many cases leads to extraordinarily inaccurate estimates of outcomes. The level of the FTSE 100 is a common investment anchor for clients partly because it is often on the news and is a relatively simple benchmark to get to grips with. At the end of the day whatever the level of the market, it is just a number, in and of itself it is meaningless and your investment portfolio is likely to be very different.
Mitigation strategy: Do not allow yourself to get hooked on meaningless anchors.
- Trap 6: It is more familiar to me, and I get it
Humans tend to make spontaneous generalisations, based on how they are influenced by recent events, press coverage, their own experiences, and the vividness with which a situation is portrayed.
Mitigation strategy: Stand back and seek a broader perspective.
- Trap 7: I like a good story
We all love a good story and there are few better story-tellers than fund managers; much of the weekend financial press is nothing more than an advertorial by some fund manager or investment adviser with an agenda or fund to sell. The danger is that the narrative of a plausible sounding script, often full of contingent probabilities, tends to persuade us to assign a higher likelihood to the story coming true than is realistic. It’s also worth remembering that the authors of these articles don’t know you and your unique goals and objectives.
Mitigation strategy: Be a sceptic – take everything you hear or read from the industry with a pinch of salt.
- Trap 8: Short-termism and obsessive portfolio monitoring
Many investors find it difficult to see the long-term wood for the short-term trees. It would be very easy to end up chasing our tails if we gave in to the temptation to tweak or adjust our portfolio to every single item of breaking news. Focussing on recent market conditions affects our ability to make good decisions for the long-term success in meeting our lifetime purchasing power needs; a portfolio should be constructed to give the best historical possibility of meeting your unique goals and should only be changed if your goals change.
Mitigation strategy: Do not worry about short-term changes and certainly don’t focus in on how one specific part of your portfolio has performed over a short or even medium-term timeframe.
The solution: process, process, process.
Benjamin Graham, one of the great investment minds of the twentieth century, famously stated (Graham and Dodd, 1996):
‘The investor’s chief problem – and even his worst enemy – is likely to be himself.’
It is often said that investing successfully is simple but not easy; the reason it is not easy is because of our natural human emotions and behaviours. Working with an empathic, independent third party or coach, can help you avoid these common behavioural biases.
Advisers too can be subject to these biases, we see it time and again in the timing and selection culture which dominates the investment industry to the detriment of consumers. At Expert Wealth we use an evidence-based and systematic investment process to remove the emotional impact on our investment decisions. We know that a good process won’t always deliver a good outcome, but over time it raises the chances of one and should help you to achieve your goals.