The Investor 95

aul Craven, a member of the

Magic Circle, sees no incongruity

in combining a career advising

financial institutions with his love of

performing magic.The common link is

psychology. Having worked for top

financial firms, he now advises the sector

on behavioural finance or, in layman’s

terms, how to avoid some of the

psychological pitfalls that lead to poor

decision-making.

He declares:‘Magic can deceive us by

exploiting the mental shortcuts that we

all rely on to navigate ordinary life.The

successful transfer of your DNA over

hundreds of thousands of years is

testimony to how effective and necessary

those shortcuts were to your ancestors.

But they also lead to heuristics and biases

– a tendency to behave in a certain way

– which may not be appropriate in

environments like financial markets, as

they can lead us as investors into poor

investment decisions.’

Most of us will recognise the

patterns of flawed decision-making.

One is defaulting to a ‘do nothing’

approach. Equally widespread is the

ingrained tendency to follow the herd

and thus sell at the wrong time in an

investment cycle.

Theoretical economists’ long-held –

but simplistic – assumption used to

be that investors always behave rationally

so as to maximise returns.

Behavioural

scientists have now cast aside that

view and instead have identified

a clutch of behavioural biases that are

embedded in our ingrained decision-

making processes.

Research suggests that certain behavioural traits

lead to poor investment decision-making.Awareness

of the pitfalls will keep investors on their toes

ByVictor Smart

Among the most frequent is loss

aversion.As investors, we are more

sensitive to the fear of losses than we

are to the potential for gains. Studies

suggest that people weigh losses more

than twice as heavily as gains.

Some

people may have a larger appetite for

risk than others, but we all tend to fret

most about getting locked into a loss.

Indeed, the idea of a loss can be so

painful that people tend to delay

recognising it until forced to.

Ordinary investors tend to sell shares

on which they have made a profit too

early, irrespective of the outlook for

those particular shares.

Another recognisable problem

comes from relying too heavily on the

first piece of information we receive.

Psychologists refer to this as ‘anchoring’

– we tend to ‘anchor’ our thoughts

to a somewhat arbitrary early reference

point.This mental quirk, of course,

explains the perennial appeal to

consumers of sales and discounts on

goods where big sums appear to

be slashed from what we believe to be

the full price.

So what is the actual impact of these

biases on financial returns? In its latest

annual report, DALBAR – a Boston-

based financial services research

company – suggests the behaviour of

investors is likely to have a negative

impact on the returns they achieve.

Succumbing to short-term strategies

such as market timing (the belief that

you can anticipate moves in markets),

many investors cannot exercise the

discipline necessary to capture the

benefits that markets can provide over

longer time horizons. Based on data from

the US, the average investor achieved

just 60% of the return provided by the

broader market in 2016 due to poor

market-timing decisions.The reality is

that we are probably our own worst

enemy when it comes to making

investment decisions, DALBAR

warns.

Professional fund managers have one

significant advantage – they are trained

to understand the impact of biases and

can attempt to mitigate the risks. Much

of Craven’s work with investment

professionals is to get them to avoid

‘groupthink’ (as many decisions are

made by committees) and analyse what

could go wrong with a decision, rather

than devoting time to finding evidence

that supports a decision they have already

made. Craven says:‘Although it sounds

straightforward, countering behavioural

biases proves not to be as easy as people

imagine. People appear not to learn

from past experience.’

So what are the practical lessons?

Investing tends to require a long-term

strategy, so try to avoid allowing

behavioural biases to influence your

decision-making, particularly in the

short term. Remember to focus on your

long-term financial goals and the reasons

why you invested in the first place.

Markets will move up and down

and periods of volatility are inevitable.

However, bear in mind that with

investing it is not the journey – only

the destination – that matters.

Professional fund

managers are trained

to understand the

impact of biases

Stocksy. Sources: 1 investopedia.com, August 2017; 2 James Montier,

Behavioural Finance

, 2002; 3 psychcentral.com, August 2017; 4 ifa.com May 2017

THE INVESTOR

BEHAVIOURAL FINANCE