Behavioural finance has a problem: turning knowledge into solutions that actually work. Investors often know about the most common investment biases and how emotions can cloud their judgment; and yet, they still can’t help falling victim to them.
However, there are strategies you can put in place in advance to reduce the impact of ill-judged behaviours on your investment returns. I took Oxford Risk’s new online course, ‘The art of behavioural investing’, to find out more about it – this is what I’ve learnt about the theory, and about how to turn it into simple actions that can give your portfolio a boost.
It’s a feature, folks
A key premise of behavioural investing is that investors are human beings, and as such they have emotions. This can’t be helped, and denying those emotions is actually what gets us into trouble in the first place. As the course’s instructor, Greg Davies, head of behavioural finance at Oxford Risk, puts it: it isn’t a flaw, it’s a feature. For the uninitiated, “it isn’t a bug, it’s a feature” is a phrase that software engineers use when something in their work looks strange but was actually done on purpose (or sometimes, ironically, to joke about something that is indeed a mistake or a quirk of the code – make of that what you will).
I find it an interesting premise because there is a tendency among seasoned investors to assume that experience will save them from basic mistakes. To an extent, this checks out: for example, living through multiple market crashes should hopefully teach you the importance of staying put and avoiding panic selling.
However, experienced investors, and even professionals, are also prone to emotionally driven decision-making. For example, a classic mistake people make is buying investments that have recently done well, then getting frustrated when they start underperforming, and moving on to the next shiny thing that has in the meantime also become overpriced.
The Investors’ Chronicle Portfolio Clinic shows how prone investors are to this kind of behaviour. We tend to feature experienced investors who started several decades ago; yet, they often have too many holdings (dozens), do not always have a clear strategy in place and make quite a lot of impulse buys.
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Behaviour gap
Certified financial planner and author Carl Richard has fallen foul of some of these practices himself in the past, and says of his initial experience: “I thought it was just me. I thought I was just bad at my job. I had the best training but I kept making this mistake. I was [even] going to leave the industry.”
Instead, he came up with the concept of the ‘behaviour gap’, to explain the difference between investment returns (those generated by a sum of money left in an investment for a certain period of time, such as a decade) and investor returns (what people are able to achieve in practice, once you account for the almost inevitable tinkering).
Oxford Risk estimates that the gap equates to about 1.5 to 2 percentage points a year on invested assets – simply due to poor timing and emotional decisions. When you add the cost of being too cautious, for example by keeping too much money in cash, studies suggest that the average investor loses about 3 percentage points a year in total. If that seems high to you, I agree. But even half of this figure adds up to a remarkable sum over a lifetime of investing.
The chart below shows the potential effect of the behaviour gap on your money. A £100,000 portfolio that returns 8 per cent a year will be worth about £430,000 after 20 years; cut those returns to 5 per cent a year due to poor calls and a cash overweight, and the final figure is just £250,000.
Write it all down
The first step towards solving a problem is admitting that you have one – in this case, emotions clouding your judgment when making investment decisions. But how do you avoid it?
The trick is creating a system when you are calm: one that the future, emotional you cannot easily bypass. Davies likens it to the story from The Odyssey, where Ulysses asks his crew to tie him to the ship’s mast so he can’t fall for the sirens’ singing, which lures sailors to their deaths.
One way of coming up with your own system is to create your ‘investing constitution’. This is a document that details your investment approach and strategy: your goals, risk appetite, asset allocation, rebalancing rules and investments you have decided to avoid.
“I once kept losing money trading currencies. Eventually, I added: ‘No currency positions’ [to my document]. I’m not sure anyone can predict them, but I know I definitely can’t,” recounts Davies.
Once you have written everything down at a time when you are calm and rational, find a way to ensure that you will stick with it when you are not. Do not buy any new investments or make other substantial portfolio changes without checking the constitution first. You could keep the document at your desk, if you tend to sit there when checking your portfolio. You could even give it to someone else, if you trust them to hold you to it.
Taking a breath before making changes is another good way of protecting yourself from impulsivity. The technical term here is “pause points”. For example, establish that you will wait 48 hours before acting on any investment decision, and that you will run that decision against your constitution and/or a checklist. Usually that is enough time for any emotional reaction to subside and rational thinking to kick back in – you may find that you do not want to initiate a position in that AI company after all, or that it is not actually that sensible to sell out of half of your equity holdings.
Playing devil’s advocate also helps. You may have heard of confirmation bias, which is the tendency to seek out information that supports our existing opinions and beliefs while neglecting anything that contradicts them. You can instead purposely look for arguments that go against your hunch, and see if you still want to stick with whatever change you have been planning to make.
If you have someone to discuss investing with, be it a family member or a friend, it can be useful to do this out loud. Otherwise, you can write it down. Having a record of why you bought a certain holding can be especially useful when you come to review your portfolio, because you can check whether the asset is playing the role you expected and whether the investment rationale still holds.
Diversification is unpleasant
It can also be useful to be aware of why we struggle to apply certain rules that we know are theoretically good for our portfolios – namely, diversification and rebalancing. The short answer is that they are both counter-intuitive and unpleasant.
“Diversification sounds great, but it feels pretty awful a lot of the time,” says Davies. When you stop to consider it, the reason is pretty obvious: a diversified portfolio means that, at any given moment, some part of it should be underperforming.
Personally, I think this is difficult to handle because, while it’s true that markets go through cycles, these can be extremely lengthy. Few investors will have done as well as somebody who bought US stocks 10 years ago. This doesn’t mean that putting all your money into a single country’s stock market was a brilliant call and that those who did so are amazing investors, but with the S&P 500 up 233 per cent in the decade to 20 June, it certainly feels like it.
But remember that you can’t actually know in advance what will do well, or when the tables will turn. Hence why diversification works quite well in the long term – but you will need to power through your short-term discomfort with underperforming regions, sectors, asset classes and investment styles.
Avoiding the drift
A similar dynamic is at play with rebalancing. I quite enjoyed this quote from author Jonathan Clements: “Rebalancing is the financial equivalent of flossing your teeth – you know you should do it, hardly anyone enjoys it, but the long-term benefits are worth it.”
By definition, rebalancing involves taking money out of assets that are doing well, to move it into assets that are doing less well. This can feel quite counter-intuitive and, as with diversification, it can actually reduce your returns.
However, presumably you decided on your initial asset allocation for a reason, which has to do with your risk appetite, time horizon and investment approach. Letting your portfolio drift too much in a different direction will alter that, eventually leaving you with the wrong portfolio for your circumstances.
Designing your rebalancing rules in advance can help you stick with your original plan. You don’t need to be too strict, because that can end up costing you a fortune in trading charges. But, for example, you could decide to rebalance every time your asset allocation drifts by more than 5 per cent.
On this note, you might also enjoy the concept of “anxiety-adjusted returns”, which is the behavioural version of risk-adjusted returns. Set a strategy you are comfortable with, argues Davies: the best strategy isn’t the one with the highest return on paper, it’s the one you can actually stick with when the ride gets bumpy.
This is tricky because purely from a rational, technical perspective, you should work out your strategy based chiefly on your time horizon. Will it be 10 years or more before you need your money? Then equities are the way to go.
However, your emotional comfort is also crucial for two reasons. First, because the best parts of your life happen outside of investing, and you shouldn’t be worrying too much about your portfolio, except for those few times a year when you check it. Second, because if you then sell at the wrong time and end up staying in cash through a recovery, you will lose much more than you would have done with an overly cautious asset allocation.
As ever with investing, it’s a balancing act. But by planning for your emotional reactions in advance, you can at least reduce their impact on your returns.