As anyone who has run money in the markets will agree, investing is often an emotional business. This is particularly true in volatile periods like the present.
With a range of different factors at play – softening commodity markets, the uneven global economic climate, China’s slowdown and the uncertain direction of interest rates – the risk that emotions may unduly influence investment decisions is especially high.
We believe that short-term market events and the emotions they trigger can risk material interruptions to thoughtful long-term strategies. But to counter these risks we need to acknowledge them, without losing sight of those long-term investment goals.
Emotion is a fact of investing; the challenge is to identify and address biases before they exert undue influence in the investment decision-making process. We have identified five common emotional traits, for each of which there is a solution, below:
- Unrealistic expectations: Ensuring realistic expectations for investment returns
- Loss aversion: Identifying appropriate risk levels and the “highest acceptable loss”
- Familiarity bias: Striving to reduce “home country bias” and over-reliance on the familiar
- Anchoring: Avoiding undue emphasis on a single point of reference, such as a stock index
- Overconfidence: Learning to respect the limits of one’s knowledge or investment strategy
Unrealistic expectations can be prompted by “recency bias” – the expectation that recent trends will endure – and the more familiar concept of confirmation bias, the natural inclination to search for and prioritise information that fits our preconceptions.
These might manifest themselves in an expectation, despite evidence to the contrary, for previously high-performing asset classes to remain so.
The key to countering this is to accept the reality of the market before events force a reassessment. Investors should use all available data, maintaining long-term investment plans and focusing on goals rather than short-term performance against a benchmark.
Finance professionals can counter clients’ own bias by prompting a discussion about their views rather than by providing unsolicited advice.
Putting this in the context of the rocky start to 2016, one might observe that sell-offs are a normal investing experience, even if they don’t seem so to investors lulled by a benign period.
Performance of index in 2015
Source: FE Analytics
The equity market correction that began in mid-2015 might have been a brutal experience, for example, but 10 per cent declines are actually more normal than abnormal, occurring on average more than once a year over the last quarter century in the S&P 500.
But given that there hadn’t been a market decline of this magnitude for four years until late 2015, it was natural – if illogical - for expectations to shift in line with improving conditions.
Loss aversion describes the preference of those who seek to avoid losses more than they wish to acquire gains. Dealing with this isn’t a simple question of changing the bias, especially in view of the fact that higher risk strategies tend to produce more outlying results on either the positive or negative side rather than “average” returns likely to be within acceptable bounds for the investor.
Key techniques include identifying the extent of loss-aversion and the highest acceptable loss. This in turn can form the basis of a strategy to reduce risk using effective portfolio construction, designed with both investment objectives and the investor’s risk aversion in mind.
Well-constructed portfolios are an essential element of behavioural finance.
Relevant in benign markets as much as volatile ones, we believe robust portfolios require long-term allocation choices based on more than the recent past and on more than one or a few recently high-performing asset classes – exactly the kind of thinking that limits the risks presented by short-term emotional reactions.
Familiarity bias is both an emotional behaviour and a risk run by passive investors who automatically over-allocate to domestic stocks and other investments (“home country bias”). It carries three main risks: the exclusion of alternative investment opportunities; limitation of diversification; and the assumption of unnecessary total risk.
Home country bias in particular presents concentration risks – every national equity benchmark will have a particular bias to certain industries, as well as indirect exposures to other geographies via constituent stocks dependent on cashflows from key offshore markets.
Ways to counter familiarity bias include making a conscious decision to become more familiar with alternatives – the tools exist to enable investors to judge the relative performance of different asset classes.
Another option takes us back to the key principle of effective portfolio construction: a “core and diversified” approach, based on core investments in mainstream asset classes with a marginal overlay of diversifier investments such as high yield or international small cap equity, can reduce portfolio risk while leaving room for higher returns.
Performance of indices over 10yr
Anchoring, the mental shortcut by which investors place excessive emphasis on a single reference point, is a similar inhibitor of logical investment decisions.
Investors can counter this bad habit by questioning their reference points – especially the “high water mark” of favoured stocks – and by adopting diversified benchmarks.
Over-confidence is a perennial risk for investors and is a trait frequently rooted in most of the behaviours discussed previously.
Symptoms include investors’ tendency to overestimate the accuracy of their information; to hold insufficiently diverse portfolios; to retain underperforming investments while selling winners; and to trade with unnecessary frequency.
To combat this, we believe investors should embed an investment process based on confidence in their long-term strategy, thereby lessening the likelihood of unnecessary trading and turnover.
Part of this process is frequent self-assessment and appraisals of trading history, identifying in particular incidents of unnecessary trading that had a deleterious effect on performance.
These emotional characteristics are each an understandable quirk of human nature, the flipside of the creativity and ingenuity inherent in thoughtful investing.
By acknowledging them and putting in place measures to offset the associated risks, investors can turn potential weaknesses into strengths. - trustnet
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