From The Times
March 13, 2010
March 13, 2010
Investment masterclass: fight against your instinct to make a profit
You can boost stock market returns by avoiding typical behaviour patterns
David Budworth
Since the 1960s one grand theory has dominated investors’ views of how stock markets work. The efficient market hypothesis asserts that prices accurately reflect available information and investors behave rationally. It’s an elegant idea and leads to the conclusion that it is not generally possible to beat the market except through luck or inside information.
However, it doesn’t accurately reflect the world at all times, Therefore, it can be argued that it is not particularly useful for the poor investor trying to get a handle on markets. Which is why, over recent years, a second theory has been grabbing attention. This theory, called behavioural finance, accepts that markets are not always rational but it rejects the idea that they are completely random. Although behavioural finance initially was treated with scepticism in the City, it is now playing an increasing role in investment decision-making. Bringing insights from psychology to the world of finance, it asserts that a lot of investment behaviour is based on irrational decision-making, driven by emotion rather than logic. By understanding how average investors behave and the mistakes they make, you can learn how to avoid them.
James Montier, strategist at GMO and author of The Little Book of Behavioural Investing: How Not to Be Your Own Worst Enemy, says: “Our brains have been refined by the process of evolution, just like any other feature of our existence. But remember, evolution occurs at a glacial pace, so our brains are well designed for the environment that we faced 150,000 years ago, but potentially poorly suited for the industrial age of 300 years ago, and perhaps even more ill-suited for the information age in which we now live.”
This means that investors consistently make mistakes that damage returns. Here are some of the most common and how to learn to avoid them.
The narrative fallacy
The narrative fallacy
Investors are easily won over by positive stories. Even when news is bad the predominant view is that things will get better. This encourages investors to favour companies that have done well in the past, even if they are expensive and can create bubble conditions.
Forcing yourself to focus on the facts should make you a better investor.
Overconfidence
When investors have a run of good luck they become more confident in their abilities. A study by the University of California academics Terrance Odean and Brad Barber found that if investors have a good run on the stock market, they often take higher risks, trading more actively and usually less profitably. In gambling circles this is known as the “house money” effect. People are more likely to bet recklessly with money that they have won than money they brought into the casino.
The best way to overcome this is to stick to an investment discipline. If you have had a good run and feel like putting more money into the market, take a step back.
Following forecasts
Mr Montier claims that experts are often more overconfident than the rest of us, yet we tend to follow authority blindly. Even though experience tells us that many forecasts are wrong, we cling to them because of a trait known as anchoring. In the face of uncertainty, we reach out for any irrelevant number as support. It is best to ignore the experts and their forecasts.
Information overload
People often believe that to beat the market they need to know more than everyone else. However, studies shows that excess information can lead to overconfidence, not accuracy, as it makes it difficult to distinguish noise from news.
Mr Montier says: “We would be far better off analysing the five things we really need to know about an investment, rather than trying to know absolutely everything about everything concerned with the investment.”
Denial
Investors give more weight to information that appeals to them. Learn to look for evidence that proves that your own analysis is wrong.
Loss aversion
Studies show that we are about three times more likely to sell a stock that has performed well than one that has done badly. We hang on to investments that have lost us money, even if the evidence suggests that they have farther to fall, because we cannot cope with the regret of having made a bad decision. To overcome this, set yourself a buy and sell target and keep to it.
Groupthink
It is hard to go against the crowd, which is why investors tend to follow the herd and buy the latest hot stocks and funds. You can turn this to your advantage by picking stocks that are cheap and out of fashion. But be warned: this strategy takes courage.
Focusing on outcomes
Mr Montier says: “When every decision is measured on outcomes, investors are likely to avoid uncertainty, chase noise and herd with the consensus.”
Instead, he argues, investors should focus on the process by which they invest: “The management of return is impossible, the management of risk is illusory, but process is the one thing we can exert an influence over.”
Leave the herd behind and get ahead
One of the key tenets of behavioural finance is that investors follow the herd, although chasing the latest fad often ends in disaster.
In the late 1990s, tech funds were all the rage and investors poured billions into them on the back of a run of stunning performances. After the tech bubble burst in 2000 many lost 90 per cent of their value.
Commercial property funds were the runaway bestsellers of 2006 . But this rush of money proved to be the last hurrah in an already overinflated sector.
So which funds have been selling like hotcakes recently? Bond funds were one of the big success stories of 2009, attracting £9.9 billion of net retail sales, according to the Investment Management Association, and investors who took the plunge were rewarded. Standard corporate bond funds produced returns averaging 14.6 per cent last year, while those investing in riskier high-yield bonds returned 46.4 per cent. However, many fund managers warn that any investor expecting a repeat of this performance in 2010 will be disappointed. More recently property funds have been the top-selling sector, with net retail sales of £373 million in January.
So if you want to try to overcome your herd instincts, what should you be investing in now? Alan Steel, of Alan Steel Asset Management, says: “The contrarian would shun property investments and gilts in favour of equities.
“Even though stock markets have soared in the past 12 months, sentiment is still very depressed about the future prospects of both equities and the global economy. Buying shares is still a contrarian stance.”
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