Conversation 6: Let’s talk behavioural psychology

This is the sixth article in a series designed to help you get the very best out of your financial adviser. If you’re already a client of Sovereign Wealth Partners, hopefully you’ll recognise the process and feel empowered to revisit these conversations with us at any time. Your aim is to be confident that you can live an extraordinary life backed by wealth that’s beautifully aligned with everything that’s important to you. Remember though, extraordinary advice partnerships are elusive. So, the conversations are probably not what you’d think.

We’re all only human and every one of us comes with a set of hard-wired processes that enables us to make decisions.

At their most basic, these processes were honed by our ancestors on the savannah, where instant “fight or flight” decisions required very fast thinking using short cuts*, experience and intuition.

Successful investing requires great decision-making skills too.  But not fast decision making skills.  Time and time again we find that when it comes to investment decisions, the markers and short cuts we naturally fall back on are actually unhelpful.

Experiments have shown that for investors, the pain of a loss is around twice as intense as the pleasure of a profit.  Perhaps that’s because back on the savannah, rule number one was to stay alive.  I’ll concede that’s a rule worth remembering if you’re about to bet everything on red at the casino.

But in rational portfolio investment the rules are different; to make money we have to be even handed and unemotional.  In a well-diversified portfolio, the investments and risks are carefully spread.  A dollar of return is still a dollar whether it’s a loss avoided or a profit gained.

It’s not easy being a cold-hearted investor but the good news is that we can do better if we recognise the behavioural psychology involved.  Even better if we talk over our portfolio decisions with an adviser who will challenge the lazy thinking. 

With this in mind, here are a few behavioural traps to avoid:

1. The underperforming investment:  “I won’t sell it until I get back what I paid’ This common scenario contains two huge behavioural traps.  Firstly, the desire to avoid the pain of a loss through reluctance to sell out of a losing position.  This is known as loss aversion.  Because losses are felt more keenly than profits we have a tendency to stick with an increasingly shaky investment when we should be reallocating capital to the new best opportunity.

The other trap is anchoring, which is similar to the bias of framing.  In this case we have anchored our sale decision to the cost price.  This might seem significant to us but is now actually a sunk cost.  The actual cost price that was paid has no relevance to the optimal buy or sell decision going forward.  The decision to continue to hold an investment should be about the “opportunity cost’ which is the benefit foregone from NOT holding the best set of investments available right now.

Subject to transaction costs and tax, every investment you hold should be like a player on an all-star team.  None past their prime, each should have amazing prospects.  Continuing the analogy, the overall team needs to play well in all conditions, with elements of attack and defence.  Using a consistent process, new players are brought in to the team if their potential is good enough. Overshadowed players are not forgotten but they are dropped back onto the reserve bench.

2. The news item:  “I’m going to buy it – these guys are on a roll and it’s all over the papers” The first trap here is that the decision is based on a journalist’s story in the mainstream media.  If there is anything new in the story that hasn’t already been factored into the price by professional investors, then it will be the moment the story hits the wires.

The next trap is that we naturally give memorable recent news a higher priority than all the other relevant considerations. This bias is known as recency, availability or memory bias.  Not only that, try to remember that seasoned investors warn us to ignore the media headlines.  The papers are meant to sell today and tomorrows story will always be different.

3. The easy money:  “Everyone’s making money out of it so I’m joining them” Following the crowd feels comfortable because there are plenty who agree with you and the price movement is likely to be going your way.  This known as herding behaviour.  But herd participants often suffer from group-think, over-confidence and confirmation bias.  Many of the price cycles we see in stocks and financial markets are caused by the herd thinking the same way and pushing the price well beyond a fair value.

Speculative bubbles occur when the herd’s narrative and confirmation bias is so compelling that rational valuation analysis is abandoned. But eventually something happens that exposes the mispricing and the herd will rush off in the other direction.

Inevitably investors come unstuck if what they bought was poor value: a famous Warren Buffet quote is that “price is what you pay but value is what you get”.   Successful investors do enough homework to satisfy themselves that what they’re paying is less than the value they’re getting.

If a purchase is made with no attention to value, the best you can hope for is to rely on the “greater fool theory” and flip the investment to someone else whilst the herd is strong.

4. The set and forget:  “You can’t go wrong with ‘buy-and-hold’” Except that the world changes.  An inspired buy decision today can be undone in a moment.  It’s nobody’s fault, the world is a complex, unpredictable place.  A great quote attributed to John Maynard Keynes is “when the facts change I change my mind.  What do you do sir?”

The best fund managers prepare a written “thesis” for each of the stocks they buy, laying out the rationale for upside, the insight that the rest of the market is missing and the catalysts that will allow the value to be realised.  Sadly, they are for internal use only!  This discipline allows them to challenge the thesis as events unfold and resist the temptation to fall in love with the stock.  Typically, at the end of every week, the fund manager has a sceptical investment committee to win over.  The aim is to only allow the stock to be held if the thesis still stacks up and there is no better use of the capital.

Long term buy-and-hold does work much better when investing in managed funds and ETF’s where the underlying components are being managed to a credible process. This may be enough in itself, although one part of our process at Sovereign is dynamic asset allocation – we monitor valuation signals to allow us to make portfolio tilts towards sectors that seem to offer the best value over the next few years.

5. The crest of the wave: “I’ll just stay with the top performers” Except, when we combine this objective with price cycles and herding, we’re likely to be buying high and selling low.  A study by US funds management giant Russell Investments found that the average annual return experienced by investors** in US various share funds between 1984 and 2019 was 2%pa lower than buying and holding the same share funds for the whole period.   The size of this number is truly frightening and an indicator that chasing returns can result in serious capital erosion from buying high and selling low.  Whilst a fund manager is only worth investing in if their returns are competitive over the long term, there is a lot more to picking funds than today’s performance rankings.

*A great book that explores the decision shortcuts our brain makes is Thinking Fast and Slow by Daniel Kahneman ** Dollar returns experienced by those investors, taking into account inflows and outflows to and from those funds.

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