Although behavioural finance has become an in-vogue topic in recent years and provided many valuable insights into how investors make decisions; it is often fiendishly difficult to put these into practice. Whilst there are some notable exceptions (such as Save More Tomorrow in the US), much of the work in this field describes what we do, not necessarily what we can do about it. The purpose of this short piece is to highlight five ideas, influenced by behavioural science, which could lead to better long-term investment decisions:
1) Check your portfolio less frequently: Whilst the benefits of transparency and access are significant they create a range of behavioural problems for the long-term investor. Quite simply – the more frequently we check our portfolios, the more myopic and risk averse we are likely to become in our decision making. Viewing our portfolios on a daily basis creates an often irresistible urge to react and trade, often at the worst possible times. Although difficult, once we have a sensible investment plan in place, we should try to restrict our observations to a meaningful and realistic level – once a month / once a quarter / once a year. A gentle nudge for private investors is to set a password for your investment account that is difficult to remember and store that password somewhere it takes a modicum of effort to retrieve. Making something that little bit more difficult, can have a dramatic impact on our behaviour.
2) Don’t make emotional decisions: How we ‘feel’ at any given point in time can have a material influence on the manner in which we perceive risks and assess opportunities. Making an investment decision in an emotional state – such as excitement or fear – is fraught with problems. If there is any chance that emotion is overwhelming your thinking – postpone the decision. If the idea was a good one, it is still likely to be tomorrow, or next week.
3) Make doing nothing the default: I vividly recall sitting in an investment meeting at one point in my career and debating what our reaction should be to a particular period of market tumult. Certain participants advocated taking the opportunity to increase risk, others proposed becoming more cautious – both contrasting views were considered by the group to be credible. However, my suggestion of doing nothing was treated with incredulity – something is happening, we must react. The more we are bombarded with news, information and opinion the greater the temptation to be busy fools and justify our existence as investment managers by taking action, any action. For a variety of reasons doing nothing is the hardest decision to make for an investor, but it is often the correct one.
4) Choose sensible reference points: Loss aversion is a well-understood concept, but the important role of reference points is probably understated. We experience losses relative to a particular level, value or benchmark, and what that reference point is can materially impact both how we think about investment performance and the decisions we make. Unscrupulous investment managers can attempt to exploit this phenomenon by shifting the benchmark, or trying to create a new reference point when reporting to clients: “Whilst your balanced portfolio lost 7% during the period, the NASDAQ Biotechnology index fell by 23%…” There is no perfect solution here and the decision will be specific to each individual, but choosing a prudent, consistent reference point (or selection of reference points) at the outset of an investment portfolio can mitigate future behavioural pitfalls. An example of a reference point problem would be comparing the performance of your cautious portfolio to a broad equity index in a bull market, experiencing this as a ‘loss’ and deciding to abandon your investment discipline to assume more risk.
5) Write a pre-mortem before making an investment: An idea developed by Gary Klein whereby, prior to embarking on a course of action, you imagine a future state where this action has ended in failure, and then list the reasons why it has gone wrong. This approach can be easily applied prior to making an investment, where you envisage the future failure of the decision and attempt to identify the causes. It can be particularly useful in a group situation as it gives individuals the freedom to play devil’s advocate. The technique is effective as it forces us to engage with the prospect of being wrong (which is often unpalatable) and can serve to puncture the overconfidence that can often plague investment decision making. It is also a useful learning tool as we can retrospectively review what we considered to be the primary risks at the time of making an investment.