Protecting investors from themselves

CONFRONTED by extraordinary trends or events, investors are often seduced into making decisions that rival their predefined long-term plans and act against their best interests. This happens in both bull and bear markets. The study of behavioural economics sheds light on this, often counterproductive, behaviour.

Our irrational nature

Classic economists tend to characterise economic factors as highly rational and unemotional. Stockmarkets however, are, in fact, defined by interactions between people. Behavioural economics, an academic discipline, which started nearly two decades ago, examines the psychological perspective of how people interact with market forces.

Behavioural economics applies to every level of investing, and the findings can be disturbing. In many cases, investors are not as rational or objective as they think they are. In failing to spot and understand their weaknesses, investors often cause their portfolios more harm than good.

The way to control this ‘human factor’ in investing is to develop a long-term, diversified investment plan. A multi-manager approach, for example, would help keep these plans on target. That way, investors do not have to think about making frequent, and often stressful, decisions and risk making regrettable mistakes.

The study of investor behaviour

Dr. Richard Thaler is a professor of behavioural science and economics at the University of Chicago and has published books on the subject. He is also the principal of a California asset management firm, which combines fundamental research with insights from behavioural finance to gain a competitive edge over the market.

Using a variety of research methods, Thaler and other behavioural economists have gained objective insights into investors’ biases and the negative actions they produce. Interestingly, Thaler explains that poor decision-making is not more common during volatile market activity. “There’s no evidence that we’re less rational during volatile times. Rather, those periods simply present more opportunities to act foolishly.”

Five common mistakes

Thaler has identified common pitfalls which investors should avoid:

1)Overconfidence. Investors overrate their ability to select winning stocks or funds. But evidence suggests that individuals don’t do better than chance. The internet exacerbates the problem. By providing easy access to information, it creates an illusion that investors see information not available to others, thus gaining an advantage. In fact, everyone has access to this data. Moreover, once this data reaches the internet, it is already dated.

2) Loss aversion. Research indicates that a loss causes about twice as much pain as a gain causes pleasure. During periods of market volatility, investors experience the sense of loss more acutely. Moreover, they fail to sell when stocks are heading down, refusing to acknowledge a mistake.

3)Return chasing. When the market goes up, too many investors delay buying – often until just the wrong time when share prices have peaked and are about to head down. “There’s lots of evidence that people think what goes up will always go up. Worse still, many investors have developed an aversion to equities that has kept them from getting back into the stockmarket at levels far below those of the late 90s and early 2000.”

4)Investing too much in an employer. “This is starting to change,” Thaler says, “but not quickly enough.” People learned the wrong lesson from Enron. “They think they shouldn’t invest in their employer if it’s cooking the books. But the right lesson is, don’t put the majority of your assets in any one stock.”

5)Refusal to sell winners. How many investors bemoan the profits they could have had if they had sold in time? “Diversification is the key. If a share price or fund has gone way up and become a big part of a portfolio, trim it back.” Maintaining an asset allocation model offers the discipline required. “Learn from professionals. Portfolio managers have rules limiting the position of any stock or sector.”

A plan as self-defence

An antidote to behavioural mistakes could come in the form of a well-defined, long-term investment policy. If you manage your portfolio yourself, a good way to ensure you stick to it, especially in uncertain markets, is to write it down. This helps you do the right thing, which is often the exact opposite of what your instinct tells you. You need to be objective and willing to learn from mistakes and move on.

The best way, though, to avoid these errors is to use the services of an independent financial adviser. A professional adviser will not make emotional decisions about your investments. Instead, he will be objective, study all the facts and use his experience to judge what the best decision is with regards to your long-term plan. Ultimately, your adviser will follow your instructions, but at least he will present you with all the facts and guide you through all the pros and cons so you can make an informed decision.

It is also important to have a well-diversified portfolio. Consistent with long-term planning, multi-manager funds offer a diversified approach, which spreads risk across asset classes, then adds depth to each with a multi-manager combination. The principles of diversification inherent in this system ensure the managers act defensively to build profitability in the long run. This way, you will avoid sudden, irrational reactions to short-term movements in the market.

Investors can do the right thing in spite of the pressures created by market volatility. As an investor, you can protect your portfolio from yourself – by being honest about human nature and planning and implementing systems accordingly.

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