We’re currently looking for a new puppy and I was chatting with a friend about the pros and cons of different breeds. ‘It needs to be good with children and well-trained,’ I said.
‘Yes, but remember that it’s not really the dog that needs training, it’s you,’ she replied.
How true! Our own actions are the most important decider of how a dog will behave. And the same is true of investments —it’s usually the investor, rather than the investment itself that is to blame if things don’t go as planned.
The science of Behavioural Finance has identified many mental mistakes that we’re all inclined to make and which can seriously damage our investments. These include focusing too much on recent events, being overly optimistic or overly loss-averse.
In his book Thinking Fast & Slow, Nobel prizewinner in Economics, Daniel Kahneman, identifies two very different thought processes. System 1 is instinctive, subconscious and emotional, whereas System 2 is slower, deliberative, and more logical.
We need System 1 for survival of everyday life, but it relies on several rules of thumb (heuristics) which lead to several biases that can get investors into trouble.
Studies have measured the financial impact of poor investor behaviour over time. For example, between 1992 and 2007 the UK stock market delivered an average return of 9% each year. Over the same period the average returns for a typical UK fund investor were just 4.9% each year. In money terms, a £100,000 investment in the FTSE, left untouched, would have grown to £281,000. In contrast, the average investor’s portfolio would have risen to 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 huge differences, but just knowing about the issues does not solve the problem by itself.
Global stock markets are currently up by more than 50% over the past three years, and investing feels ‘safe’ again. But how will you react when for some reason they fall sharply again (which they undoubtedly will at some point)? Will your reactive System 1 thinking kick in, or will you take a more considered, rational and longer-term approach?
No doubt, 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 building a portfolio, tax mitigation etc will generally add value to my clients. It’s also what they look for when they take me on.
However, it is the less tangible elements of my advice, over time that may turn out to have the greatest value. By trying to coach my clients through periods of market volatility, and helping them apply System 2 thinking to make more considered choices (and not to be their own worst enemies), the net gains are likely to dwarf those from the more obvious services we offer.
*An Examination of the Difference Between UK Fund Returns and UK Fund Investors’ Returns, July 2007. Lukas Schneider.
Ian Thomas is authorised and regulated by the FCA. This article is intended to provide helpful information of a general nature and does not constitute financial advice.