Call the thought police
Investors will improve their chances of success if they are aware of their dodgy decision making
When I recently sat down to sort out my tax affairs for my accountant, I was shocked at how often I’d traded shares over the past two years. I’m still not sure why I was such an active trader but after reading a paper on investor bias from Russell Investments I think I may have been guilty of over-confidence.
This is one example of behavioural biases by investors that can impact their portfolios. People tend to overestimate or exaggerate their ability to successfully perform tasks, says the paper, and this can lead them to trade too often.
The paper, “How to avoid common behavioural biases and their detrimental impact on investor portfolios,” also identifies “herding”, which can result in people buying high and selling low; “familiarity”, which leads to a home country bias in selecting investments; and “mental accounting”, which can result in naive or inadequate diversification.
“Not being confident enough can also be a problem with investing,” says Simon Russell, founder and director of Behavioural Finance Australia (BFA). You don’t want to be so under-confident that you’re only in cash and your money is going backwards.
Over-confidence means you are less likely to diversify widely, says Russell. “For example, you know the three best shares so why invest in anything else?”
“Diversification is the first rule of investing,” says Scott Fletcher, client portfolio manager at Russell Investments, the publisher of the investor bias paper.
BFA’s Simon Russell agrees that over-confidence also leads to frequent trading, which also has cost (trading fees) and capital gains implications – a lesson I have just learnt!
It also makes investors less likely to listen to third-party advisers or use other experts, he says. Filtering the noise from information overload is a key problem for investors, says Russell, but distracting noise is not usually around tax and capital gains implications.
“Awareness of how and when investment decisions can be adversely impacted by decision-making biases is a good first step to improved decision making but it’s not a panacea,” says Russell.
Stop and think
Investors need to be clear about the most important drivers to achieve their investment objectives and make a list of these. Practising “meta-cognition” (thinking about their thinking process) and “mindfulness” (in the sense of being aware when they feel the impact of information overload and complexity) should also help, says Russell.
He also recommends investors look for supports, such as little barriers. For example, don’t memorise your trading pin – just having to look it up makes you pause, says Russell, noting studies that show when you have to click through twice to reach a website rather than once, you are less likely to do it.
Also try to have someone who keeps you accountable, such as a spouse or a financial adviser; ideally a person who understands your processes.
Setting up a practice portfolio can also be a good way to test your processes. “If you’re tempted to take your money out of a well-performing industry super fund and set
up a self-managed fund, then set up a dummy portfolio for a couple of years – you might change your mind,” says Russell.
“Try to set up a disciplined decisionmaking framework that minimises the extent of emotional responses,” says Russell Investments’ Fletcher. The paper suggests a journal approach, reviewing portfolio decisions. “This can encourage decisions when markets are irrational, helping investors become aware of inherent biases so they can be avoided.”
The first step in investing is to know what your objective is and the sort of assets you need to get there, says Fletcher. “And the journey is just as important as the destination.
“Work out what asset mix you need to meet your objectives, the best way to access the assets and what you may need to change along the way.”
Be especially aware of “familiarity”, which encourages investors to invest locally, and “mental accounting,” which can lead to naive diversification, when setting up your portfolio, says Fletcher.
Home bias means that 75% of Australian retail investors hold only domestic shares, despite Australia making up less than 3% of global market capitalisation, says the Russell Investments paper. “Our global analysis shows that regardless of which home country the investor resides in, this phenomenon is shared across most countries.” This exposes investors to significant country-specific risk.
Naive diversification can occur due to our hard-wired brains looking for simplification and generalisation. This leads to a tendency to separate money into separate accounts and overlook the aggregate investment strategy. “This can lead to unintended concentrated risks in portfolios and, at worse, poorly diversified portfolios,” says the paper.
After an investor sets up their portfolio, the other biases they have to watch for are over-confidence and herding, says Fletcher. He likens setting up a portfolio to choosing a roadworthy car and managing your portfolio to driving that car in a way that gets you where you are going safely. Alas, the two things don’t always go together!
“Contrary to the key of successful investing – buying low and selling high – many investors end up doing the opposite,” says the paper. A herding bias, which makes us want to follow the crowd, can trigger this. Greed, where investors strive to extract every dollar of a position before selling out, may also be responsible for buying high and selling low.
“Some investors may sell at low prices as the market is falling to avoid more losses despite the investment being a sound one and helpful to achieve their long-term objectives. They may also miss out on true buying opportunities for fear of negative market sentiment continuing the downward trend.”
“It’s dangerous for investors to look in the rear-view mirror, trying to pick winners based on the last couple of years,” says Fletcher. The average investor’s inclination to chase past performance has cost them 1.8% a year in the 34 years from 1984 to 2017 based on global analysis by Russell Investments.
Scott Phillips, general manager of financial adviser Motley Fool, agrees that looking at past history can be a distraction. He labels it an “anchoring” bias. It leads to attitudes like “not selling because the price is down” or “surely you can’t go broke taking a profit”.
“Stop looking at past history, assume it hasn’t happened,” he says.
Look to the future
One way to avoid anchoring is to not record your cost base in your list of shares, so you can’t readily see how much you have made or lost on a particular stock.
“Look at the company rather than the stock.” You want to make a decision if a particular price is good based on the future. Ask if the company is becoming relevant to more people. Flight Centre is an example of this. “About 18 months ago the share price was down because of factors in the industry, but if you looked at the top-line numbers you would see that long term more people were booking more trips.” Flight Centre's share price slumped to around $28.50 in March 2017; at the time of writing it was $67.
“Look at the market opportunities for companies.” For example, telcos used to be flavour of the month but they all grew and the market was saturated.
“Corporate Travel Management was a company we saw had opportunities and we recommended it in August 2012 when it was around $2.26 and twice later, and now it’s increased about tenfold,” says Phillips. At the time of writing the share price was about $29.
“We recommended Corporate Travel even as its price rose,” he says. “Don’t be afraid to pay higher prices to buy high-quality businesses. We picked the company because it was a high-quality business with a passionate founder.” The quality of the management is very important, he says.
Another investor bias is appeal to authority – “something well known must be good” – which leads to investors favouring blue chips, says Phillips. Separate the popular and well known from the successful by applying the same processes as you do to avoid anchoring bias.
If you find it just too hard to get a handle on your investing biases, a robo adviser might be worth considering. These digital advice platforms claim that they can help take the emotion out of investment decisions and overcome unhelpful biases by regularly rebalancing portfolios.