Behavioural finance is a discipline that draws on psychology to explain cognitive and emotional errors made by investors. It is a corrective to the efficient market hypothesis of traditional economics, which, in portraying investors as sublimely rational wealth maximizers, and prices as perfectly and instantaneously reflecting all information, has been criticised both for failing fully to explain market volatility, and for being contrary to common sense. In the global equities team, we believe that markets are not wholly efficient, and our processes are designed to exploit mispricing. Here are a few typical behavioural biases of which all investors should be aware.
The market over recent months has been characterised by violent short-term trends. So it has been easy for investors to herd, that is, thoughtlessly to imitate others. December 2018 was the S&P 500 index’s steepest December decline since 1931 (-9.2%); and January 2019 its strongest start to a year since 1987 (+7.9%). Herding leads investors to panic and sell after market falls, and to become overconfident and buy at the top of rallies.
Take a calm, long-term perspective, and have confidence in judgments backed by evidence, even if temporarily contradicted by others’ short-term behaviour.
The pain of loss is felt more keenly than the pleasure of profit. This principle extends beyond finance: studies show that in interactions between married couples, it takes five kind comments to offset one critical comment. Loss aversion can lead investors to behave irrationally, and, after several years of low volatility prior to 2018, many have forgotten how to handle losses.
Try to adopt a broader view that sets losses in the context of overall profits. As well as long-only funds, my team also runs market neutral funds, in which the short book plays an important role in alpha generation, so we are all well aware that share price falls can be profitable.
A focus on data that merely confirms previous beliefs. Such is the volume of information available to fund managers that it can be very difficult for them to avoid unconsciously filtering out data that would contradict their opinions.
We favour a systematic approach, enabling us to analyse large investment universes according to a disciplined and objective methodology. Our research programmes with external academic advisers help us maintain objectivity.
Anchoring is the tendency to rely heavily on one piece of information – often a reference point adopted at an early stage. An example is the belief that some asset classes, such as utilities equities, real estate equities, the yen, or gold, are all-weather safe havens. Yet during 2018, all the above were negatively correlated with the Vix index, indicating that they tended to fall when S&P 500 volatility spiked.
Try to consider objectively as much up-to-date information as possible before making decisions.
People tend to value something they own more highly than something they do not. This can lead to investors holding onto underperforming stocks for too long and failing to form a fair view of them.
Although stocks are legally rights to ownership in companies, they can be dominated by market- rather than company-specific factors. We see ourselves as temporary holders of stocks, and use them to take advantage of changes in the market environment.
Beliefs are often insufficiently revised even when new evidence is presented. An example is rigidity of investment style. A value style (buying relatively cheaper stocks) has outperformed over the last 100 years, attracting academic interest and leading some investors to strongly believe in it.
However, this is of scant comfort to those who have suffered from value’s significant underperformance during the last decade.
Be willing to change accustomed behaviour when faced by a new situation. It is often advantageous to flex investment style in response to changes in the market environment.
An excessive emotional response can cause havoc. Even experienced fund managers can fall prey to overreaction, abandoning their investment process and taking irrational decisions after a period of underperformance, for example. Overreaction makes an interesting contrast with conservatism. I would urge flexibility of investment style (such as value, growth or momentum), but consistency of investment process (the steps that are followed before arriving at investment decisions).
Try to keep faith in a sound, disciplined investment process – even during periods of short-term underperformance. Improvements to a proven investment process should be incremental and well-researched.