There was a recent article in the FT describing how retail investors in Korea had suffered huge losses after a sharp reversal in the performance of AI-favourites such as Samsung and SK Hynix. The severity of the falls led one investor to ask: “When can I get out of this hell?” That such market moves can have an impact of this magnitude is facilitated by innovations such as single stock and leveraged ETFs. This is another example of where innovation can amplify the cost of our behavioural biases.
It is irrefutable that most of us have a range of behavioural traits that are ill-suited to making sensible investment decisions. We want to make money quickly, we naively extrapolate recent trends, we chase performance, we are overconfident in our own abilities, and we ignore risks that are not obvious to us. The critical question is not whether we are susceptible to such destructive tendencies, but rather how easy it is for us to act upon them.
From the perspective of behavioural mistakes, we should care about two aspects: their frequency and their magnitude. The cost of poor investor behaviour is dictated by how often we might make errors and the impact of those errors.
In a world where technology has made trading easy and frictionless, and activity is vigorously encouraged, we should expect the frequency of behavioural mistakes to increase. This is a problem inevitably exacerbated by the sheer amount of financial market noise we are exposed to.
It is not, however, simply the ease with which we can make imprudent choices; it is how consequential they are when they occur.
As well-demonstrated by recent events in Korea, the ability of investors to risk catastrophic losses – through leveraged vehicles, options or even highly concentrated funds – has never been greater.
Innovation has seemingly created an environment where investors will inevitably make more rash decisions and be more vulnerable to disastrous, irrecoverable outcomes from those choices.
It is possible to frame this situation as a case of technological progress in the investment industry inadvertently promoting poor and consequential investor behaviour. This is often not the case. Rather, the purpose of much innovation is explicitly to benefit from clients’ behavioural biases – they are known and exploitable. Typically, retail investors bear the cost, while other parties benefit.
For any type of investment innovation, there are three questions that need to be asked:
- Why does an investor need it? (There is a big difference here between need and want; just because you can sell it doesn’t mean you should)
- What behaviours does it encourage?
- Who stands to benefit from it?
If the innovation is not encouraging better investor outcomes, net of the behavioural impact, what purpose does it serve?
My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).
Behavioural Investment 