We are looking for a new family pet at the moment – a puppy – and I was recently discussing the pros and cons of different breeds with a good friend of mine.
‘It needs to be good with children and well-trained,’ I opined.
‘OK, but don’t forget: it’s not really the dog that needs training, it’s you,’ she replied.
How true! Our own actions are the most important determinant of how a dog will behave. And the same is true of investments: it is usually the investor, rather then the investment itself, that is to blame when things go wrong.
The field of Behavioural Finance has identified numerous mental errors that all of us are prone to make and that can seriously damage our wealth when we invest. These include focusing too much on recent events, over-optimism and loss-aversion, amongst numerous others.
Nobel prizewinner in Economics, Daniel Kahneman, in his book Thinking Fast & Slow, identifies two very distinctive modes of thought. System 1 is instinctive, subconscious and emotional, whereas System 2 is slower, deliberative, and more logical.
System 1 is essential for everyday life – we wouldn’t survive long without it – but it relies on various rules of thumb (heuristics) which are what lead to the various biases that get investors into trouble.
The costs of poor investor behaviour
The costs of poor investor behaviour have been measured in studies of investment returns over time. For example, between 1992 and 2007 the UK stockmarket delivered an average return of 9% each year. Over the same period the average UK fund investor’s returns averaged just 4.9% each year. Put another way, a £100,000 investment in the FTSE, left untouched, would have grown to £281,000. In contrast, the average investor’s portfolio would have been worth only £178,000.*
Investing in the market, or with a particular ‘star’ fund manager, after – rather than before – a period of strong performance, and then panic selling during crises are the obvious reasons for these shocking figures, but just knowing about the issues does not solve the problem by itself.
At the time of writing, world stockmarkets are up by more than 50% over the past 3 years, and investing feels ‘safe’ again. But how will you react when some as yet unknown factor causes them to fall sharply again (which they undoubtedly will at some point)? Will your instinctive System 1 thinking kick-in, or will you take a more considered, rational and longer-term approach.
Put like that, most of us would like to believe the latter, but then 80% of us also think we are better than average drivers!
As a financial planner, the technical aspects of portfolio construction, tax mitigation and so on will generally add value to my clients. It’s also what they expect when they engage my services.
In reality, however, the true value of my advice, over time, may turn out to be less tangible. By trying to understand in advance how people are likely to react during periods of market volatility, acting as their independent financial coach through good and bad times and helping them apply System 2 thinking to make better decisions (and not to be their own worst enemies), the net gains are likely to dwarf those from the more overt services we offer.
*An Examination of the Difference Between UK Fund Returns and UK Fund Investors’ Returns, July 2007. Lukas Schneider.