Humans and investing

When it comes to investing, customers are not always as rational as they think they are and often reduce their returns by poor investment behaviour. The recent market volatility may exacerbate these issues and lead to investors suffering far worse outcomes than they should. Advisers have an important and valuable role in helping their customers avoid or mitigate these issues.

The behaviour gap

Much of economic theory is based on the belief that individuals behave in a rational manner and that all existing information is included in their investment process.

Researchers continue to provide evidence that rational behaviour is often lacking. The study of behavioural finance attempts to understand and explain how human emotions influence investors in their decision-making process.

While there is a debate about how best to measure the gap between the return we should achieve and that which our poor behaviour delivers, there is little doubt about whether it exists and what causes it. Estimates put the behaviour gap between just over 1% and over 4% (though there is dispute at the efficacy of the latter's methodology), see chart1.

Figure 1 - Estimates of the behaviour gap

 Estimates of the behaviour gap

See references for links to published results and methodologies.
* Given for the most actively trading investors in sample.

Source: Betterment

So how irrational are we?

Here is a quick summary of some of the behavioural theories and their impacts.

A. Regret theory

Regret theory deals with the emotion people experience after realising they've made an error in judgment. Faced with the prospect of selling a fund, investors become affected by the price at which they purchased the fund. They avoid selling it to avoid the regret of having made a bad investment, as well as the embarrassment of reporting a loss.

Regret theory can also impact investors when a fund that they had considered buying has increased in value – the feeling of having missed out.

B. Mental accounting

Humans tend to place events into 'compartments' and the difference between these compartments sometimes impacts our behaviour more than the events themselves e.g. the hesitation to sell an investment that once had large gains and now only has a small gain.

C. Prospect/loss-aversion theory

Prospect theory suggests people express a different degree of emotion towards gains than towards losses. Individuals are more distressed by prospective losses than they are happy from the same size gain – advisers don't get calls when portfolios rise by £100,000 but they do when they fall by £100,000!

Prospect theory also explains why investors hold onto losing funds: they often take more risks to avoid losses than to realise gains. Gamblers on a losing streak will behave in a similar fashion, doubling up bets to try to capture what's already been lost.

D. Anchoring

In the absence of better or new information, investors often assume that the market price is correct. People tend to place too much credence in recent market views, opinions and events, and mistakenly extrapolate recent trends that differ from historical, long-term averages and probabilities.

E. Overreacting

Investors become very optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become overly pessimistic during downturns. A consequence of anchoring or placing too much importance on recent events, while ignoring longer term data, is an over- or under-reaction to markets. So, we see prices falling too much on bad news and rising too much on good news.

F. Overconfidence

People generally rate themselves as being above average in their abilities (apparently 90% of us believe that we are better than average drivers!). They also overestimate the precision of their knowledge and their knowledge relative to others. Overconfidence results in excess trades, with trading costs eroding performance.

G. Reaching for yield

Since the global financial crisis, interest rates have been at historic lows and there is growing evidence that these low interest rates increase investors' appetite for risk taking, a phenomenon referred to as "reaching for yield".

What can advisers do to help?

The key role of the financial planner/fiduciary is to be aware of these issues and to help coach investors (and themselves!) through these issues. And to employ strategies to assist.

  1. Set long term goals – use cashflow models to help and show clients what a 20% fall looks like in £s terms. Make it real for them so when it happens, they are ready.
  2. Keep an eye on costs – Morningstar found that the best predictor of fund performance is fees, simply because paying too much directly erodes your performance and directly contributes to the behaviour gap. It's wholly possible for an uneducated investor to overpay by 1% or more for a product and another 1% for their platform.
  3. Trade infrequently (and cost effectively) – use pre-funding and free switching on platforms to rebalance. Analysis in each of 19 countries has shown that performance decreases with increased account activity. "It is worth paying an adviser to make sure you don't do things!"
  4. Diversify – a carefully targeted portfolio enables customers to reap the benefits of an "optimised" portfolio designed to meet their long-term needs with an appropriate capacity for loss, without the need for regular expansive intervention.
  5. Be aware of client biases - a client who has experienced five years of 10% annual returns is likely to expect that going forward, when the reality is likely far less appealing than that.
  6. Finally, despite every effort at inoculating clients against bad behaviour, it's inevitable that some are going to panic in volatile times, which is where your just-in-time reassurance, support and advice come in.

The future

The way we are wired as humans has ensured our survival as a species over tens of thousands of years, but it turns out to be a considerable hindrance in our ability to run investment portfolios effectively. There is a clear and valuable role for advisers to help customers close the behaviour gap and flourish – perhaps that's why we are seeing a rise in robo-advisers – if humans are poor when it comes to investing we should let the robots take over?

For more information please drop me a line. David A Norman aka DAN

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