Understanding Behavioural Finance, Part Four – Why Investors get it Wrong
Too many investors start from a position of reluctance. They sit on a lot of cash and don’t think about investing until a good story comes along. That story might be: ‘The world’s a good place, markets have been rising and I’ll get in now’, which means you’re getting in close to the top and buying emotional comfort at the cost of long-term returns.
Another story that people buy into is familiarity. We know that people will constantly invest in assets that they feel more familiar with, such as home bias. People will overwhelmingly pour money into their own markets rather than foreign markets, often to a degree that is inefficient and harmful.
People who decide to buy stock in a company because they like their products is a nonsensical reason to buy a company’s stock, as if you like what they sell, presumably many other people do too. So quite possibly its price is not going to be below value, it’s going to be above value. But it makes people feel comfortable.
People will put money in their brother’s hedge fund, ‘because he’s a good bloke’, or into the stocks of the company they work for. Doing this compounds your income risk, because if you lose your job, you may also lose your portfolio. This happened in the financial crisis, and some people lost everything.
So we start off with being too passive, and only stop this when we hear a good story, so we don’t move from cash into a diversified portfolio of risk-return efficient investments. Instead we move from cash into more concentrated portfolios of good stories, which is a worse outcome.
The aggressive side is when we leave too much of our wealth doing nothing for far too long, so that when we DO go into the market, we go all-in.
As an adviser, I observe people sitting on cash for a long time, which is costly. Not being invested is the costliest financial mistake that people make.
With the money that people do put into the market, we see them over-trading and taking on more risk when they feel comfortable, which is typically when markets are doing well, and taking on less risk when they’re uncomfortable, when markets are doing badly.
While it’s good advice to buy when the market is low and sell when it’s high, our natural psychology inclines us to do the opposite, so we buy at the top and sell at the bottom. These things are costly, and people are aggressively trying to do too much when they’re in the market.
It’s one of the least emotionally engaging stories you can tell someone, but the basic rules of investing should simply be: Figure out how much you can invest; make sure you’ve got your insurance needs sorted out, don’t invest money that you know you need to draw on in the short and medium term.
Then, get it into the market in a diversified way and leave it alone. It’s not rocket science! The trouble is that investing is simple, but not easy. Those rules are easy to understand, but remarkably difficult to follow.
I see it all the time: Intelligent people, experienced in many ways and yet still making obvious mistakes. It can be staggering.
We're all the same
Greg Davies admitted that he finds himself doing it sometimes, despite having studied for 15 years and doing it in practice for 10 years. Occasionally, when making decisions for his own investment portfolio, he can watch himself making those mistakes but still does it.
Sometimes it’s quite subtle. For instance, if you need to balance your portfolio and you’re following a set of rules where you need to buy and sell a certain number of things, such as equity markets.
Yet, on the day you come to make the trade, you may read a slightly negative article about equity markets which influences you to delay your trade, or invest slightly less than you’d intended to. We distort our own decisions in subtle ways at every single point where we feel comfortable. This is often away from the direction of what the right thing to do is financially.