** Special to the Just Word Blog from Robin Powell, the UK based editor of The Evidence-Based investor and consultant to investors, planners & advisors **
“The investor’s chief problem, and even his worst enemy, is likely to be himself.”
Benjamin Graham in The Intelligent Investor (1949)
Human beings have a bias towards action. We assume that, whatever the situation, it’s better to do something than nothing. But with investing it works the other way round. Simply put, less is more.
The investors who achieve the best results are generally those who think less, worry less and do less, and have a simple, automated investment process that requires as little human input as possible. Those who do the opposite often end up sabotaging their own portfolios.
As an investor, in other words, you are your own worst enemy, and the best thing you can do to help ensure you achieve your goals is to get out of your own way.
Why Behaviour is So Important
I’m a big admirer of Carl Richards, a former financial planner from Utah, best known for using sketches to explain investor behaviour.
Carl used to work as an active manager, trying to find opportunities in the market. One day he spotted a statistic that stopped him in his tracks. He couldn’t understand why everyone around him wasn’t obsessing about it. But he did. He noticed the difference between investment returns — what would have happened if people had bought and held investments — and investor returns. This is what people actually get, based on their real buying and selling behaviour.
Carl calls the difference between investment returns and investor returns “the behaviour gap”, and, over time, that gap can be huge. Your biggest challenge is not to find the right investments so much as to keep your own behaviour gap to a minimum.
But don’t expect it to be easy. Although doing nothing sounds simple enough, it can be very hard to stick to in practice. Why? Because you have to separate yourself from the feelings of the rest of the crowd — to sit on your hands when others are frantically buying or selling — and that’s a very lonely place to be.
Six Common Behavioural Biases
Good investor behaviour means resisting natural human instincts which we’ve inherited from our earliest ancestors. These so-called behavioural biases serve us well in certain areas of life, but not in investing. Here are some examples.
- Herd Behaviour This refers to the tendency of individuals to follow the actions of a larger group, often ignoring their own analysis or the underlying fundamentals. This can lead to bubbles and crashes, as investors collectively buy or sell in response to trends or emotions rather than on data and evidence.
- Overconfidence Just as many people think they are better drivers than they really are, many investors think they are smarter than average. This is related to self-serving bias, where people tend to attribute their successes to their own skill and their failures to external factors.
- Narrative Fallacy Humans like stories. We like to force random events into tidy narratives and mistake correlation for causation. That’s why so many of us fall for stories in the financial press about investment themes, star managers or pending market crashes.
- Anchoring When we anchor, we take one piece of information, which may be only partially relevant, and use it to frame other decisions. For example, an investor might fixate on a stock’s past high price of $100, believing it must return to that level, even if the company’s fundamentals have deteriorated and the stock is now worth $50.
- Loss Aversion This is where we put a greater weight on the possibility of a loss than we do on a gain. An example is someone who worries so much about the risk of losing money in the market that they invest in “safe” assets which, in the long term, leave them poorer.
- Recency Bias This is where we are overly influenced by recent events and extrapolate them into the future. Our short-term memories dominate our decision-making process, extrapolating recent returns into the future. The consequence is that all too often people buy stocks near the top of the cycle and sell them near the bottom.
How to Manage Your Behaviour Better
Overcoming biases that have evolved over hundreds of thousands of years is not straightforward. But here are some suggestions on how to go about it.
Set Realistic Expectations:
One of the most important things an investor can do is to set realistic expectations at the outset. Markets are bound to go down as well as up, and bear markets can last for a very long time.
Depending on your age, you may be investing for 30, 40, 50 or 60 years. This means you should expect to experience many recessions and major market downturns. Each time, you will see your savings fall in value, perhaps by as much as a half.
It also pays to have a plan to what you’re going to do — or, more to the point, not do — when those episodes arise, and make that part of your financial plan.
If you know what your plan is, and you have a method for achieving it, you are less likely to be buffeted about by your emotions at difficult times. If you know why you have chosen a particular mix of asset classes, and you’re aware of the long-term history of their performance, you’re in a much better stronger position to withstand whatever the market throws at you.
Understand What Risk Means:
To manage your behaviour as an investor, you also need to have a clear understanding of risk. There’s no escaping risk as an investor — it’s inevitable — but it’s also commonly misunderstood.
There are essentially three types of risk:
The first is permanent loss of capital. The good news is that, barring a meteor strike or nuclear war, you are very unlikely to lose all of your money, although you do need to be very careful of fraudsters.
The second type of risk is inflation risk, and it’s arguably the most important. Inflation is like a silent killer, gradually eroding your capital over time, so you need to ensure you’re putting enough money away each month to avoid inflation outpacing your investments.
The third type of risk — volatility — is the least dangerous but the one that will most shape people’s experience, consume their focus and drive their behaviour.
There will always be volatility in the financial markets, especially equity markets, but bailing out once they’ve fallen can do enormous damage. Given that equities have a long history of providing rising capital value over the long run, the logical course is to take that long view and ride any volatility out.
Employ Some Mental Tricks:
You might also find it helpful to play some tricks with your mind. One of these is called “cash for a crash”. If markets crash and you are able to switch to a fund of cash to cover your spending for a year or two, you may not need to cash in any paper losses on your investments. This means that those paper losses may never materialize as real ones.
Another approach is the “envelope trick”. If you are tempted to sell because you are worried about a sliding market, write down your decision (and why you think it’s a good one) and put this in an envelope. Date the envelope, say, three months or one month away. Any reasonable distance of time is going to stop you from acting on the spur of the moment. If on the day you open the envelope it still looks like a good decision, go ahead and do it.
But what if you strongly believe the time has come to sell part of your portfolio? Well, one trick is to self-identify as someone who is renting your investments, not an owner of them. Imagine you were renting them like a car or a holiday property. Tomorrow morning, you could wake up and easily make a switch to something better. Would you indeed switch to other “rented” investments, or would you take up the same ones all over again?
Speak to Someone:
Finally, it can’t be emphasized enough that talking to others about investment decisions is one of the most sensible ways of managing your emotions and making better choices. This is especially if you are brave enough to seek out the views of people who are likely to give contrary opinions to your own.
If you’re agonising over a decision, seek the views of someone you really trust. This may be a friend or a close family member. Better still, speak to a regulated financial adviser. Ideally, the adviser should be someone you feel able to go back to whenever the need arises.
Justwealth, for example, offers clients a dedicated Personal Portfolio Manager to provide personalized financial advice. Developing an ongoing relationship with your own portfolio manager can be extremely valuable. Who knows? One day, it might just stop you making a reckless decision you come to regret.
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