‘Give yourself a D-minus for behaviour’
“There is one principle a man must follow if he wishes to succeed, and that is to understand human nature”
Henry Ford, founder Ford Motor Co
This educational article explores a whole range of behavioural traits and biases that can trip investors up and promotes the value of an unemotional, disciplined and systematic approach to investing.
Key messages:
- Human nature is a big impediment to successful investing as well as success in other areas of our lives
- Deep-seated evolutionary traits and behaviours leave us prone to making emotionally driven decisions, often using short-cut approximations for reality
- Our emotional selves tend to overpower logical selves
- Recognising a number of critical blind-spots and blinkers provides a mirror to reflect on our behavioural weaknesses as investors
- The consequence of our bad behaviour can be considerable and there is plenty of historical evidence to demonstrate it
- Do not despair, a discipline and systematic investment process can help to trump evolution and to take much of the emotion out of investing, thereby improving the chances of a successful investment experience.
Produced in conjunction with Albion Strategic Consulting, September 2011.
Understanding people before numbers
Get smart – manage your emotions
Tim Hale, author, “Smarter Investing, Simpler Decisions for Better Results”
Have you often wondered what drives you to make decisions? Ever regretted any? Thought “that was the best decision I’ve ever made in my life”?
At BpH Wealth Management, we believe that understanding what drives your behaviour and attitude to money is essential to our ability to provide the right financial plan for you. That’s why we have a relationship with DNA Behavior International, a company dedicated to helping individuals bring a better balance to their lives and to do this by discovering everyone’s unique ‘dna’ particularly when it comes to choice and money.
There are two types of behaviour – natural and learned. Natural is hard-wired from an early age. Learned is what we experience from friends family, relations and our working environment.
The science of investing
If we cannot learn wisdom from experience it is hard to say where it is to be found
George Washington
There is a new way of investing. One that is based on 50 years of scientific study. Not speculation.
Research gathered over the last 50 years, made possible by the power of computing, has given us huge insights into how markets work.
A vast bank of knowledge can show us which investments are likely to work and which are more likely not to work.
How futile the task of the active, stock picking investor
Historic evidence demonstrates that it is virtually impossible to pick individual consistently high performing stocks. It also proves that market timing can lead to more mistakes than reward.
What the evidence proves is that it is better to invest or diversify across the whole market rather than cherry pick the best performing fund. It also proves that a long-term, game of patience is best.
But,
For the long term investor, one thing is certain: there will be times when you will seriously doubt your investment strategy
Even if you opt for a balanced portfolio which has 50% in defensive investments such as fixed interest and cash, and 50% in shares, your experience in holding this portfolio will typically look like this:
- 36% of the time your investment will be falling
- 19% of the time your investment will be recovering
- 45% of the time your investment will be rising.
Your worst experience might have begun in January 1973 and for 24 months, you would have lost a total of 27%. But, your investments would have recovered in just three months.
This illustrates the danger of market timing
The next worse experience began September 2000, lasted 29 months and took 37 months to recover. This would have been a much stiffer test of your resolve.
Historic evidence does show that the stock market has rewarded investors who can bear the risk of stock volatility and stay committed.
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You can't beat the market
You don’t need to own stocks. You need to own the market
John Bogle, founder of Vanguard Funds
Active investment management, or market timing and stock picking, is hard. Or impossible. There is now an abundance or empirical evidence to confirm this.
It relies on predicting the future. How can we?
Every day we awake to the unexpected. Earthquakes, flooding, reputable banks in crisis, London bombings, 9 / 11.
So how do you protect yourself?
Own the whole market, not just part of it
You can only protect yourself from the stock market by not investing all your money in it. And, by holding high quality fixed interest which will tend to provide a return even when markets fall thus smoothing your experience.
You can’t protect yourself from general stock market risk.
You can protect yourself from individual company or sector risk
The investment returns from the sum total of human endeavor is cheaply and freely available by having an equity stake in all the companies that act as a conduit for that endeavor.
This is easily achieved through investment in the appropriate fully diversified index and passive funds which can hold thousands of companies worldwide for very low costs.
Rather than active investments and trying to pick winners, we believe in passive asset class investing
This means deciding which asset classes are worth holding and in which proportion. Then investing in such a way to ensure you are not too exposed to any particular company, sector, geographic region or individual investment manager whilst minimising the costs associated with investment management and trading.
Then holding for the long term while dispassionately re-balancing in a pre-defined way.
Dispassionate re-balancing
All asset classes move in cycles. It is not necessary to forecast or predict these cycles but it is important to have in place a pre-defined strategy of how you will deal with the inevitable asset price movements to keep your exposure to risk constant.
This enforces the discipline of sell high buy low which is the opposite of our natural inclination to buy high and sell low.
Investing is simple
Remember that the point of investing isn’t to aim for the highest possible returns. It’s to make sure you don’t die poor
William Bernstein
Once it’s understood that you can’t beat the market and control random events, you can start to focus on what you can control without the need to know what’s happening in the financial pages. Investment then becomes a discipline and a process that you can work through by taking a number of logical steps.
Investment return
Your investment return will either come from owning an asset or equity stake or lending your capital.
There are two fundamental ways of getting a return on capital:
- Owning commercial enterprises or assets such as equities or property and receiving dividends or rent
- Lending your capital to a government or company as a gilt or bond (fixed interest investment) and receiving interest.
It’s more to do with not losing, than winning
Once you understand more about investing, you begin to realise that it is more to do with not losing than winning. It’s about developing a process to improve your chances.
This you do by controlling:
- Asset allocation
- Costs
- Taxes
- Risk.
Adopting a passive approach
This means making your well researched choices and sticking with your decision. Letting us conduct annual reviews and rebalancing your portfolio where necessary.
We sell assets that have done well and buy assets that have performed poorly. Essential if we are to minimise your exposure to risk and ensure consistency over time.
This is without forecasting and recgonises that all asset classes move in cycles that do not necessarily coincide.
Our focus is on wealth management rather than stock picking or market timing
Wealth management is about giving advice that is appropriate to your whole financial and personal position.
It revolves around the things that you can control:
- Saving, spending, taxes, costs
- Financial planning with detailed cash flow modelling
- Managing relationships with your other professional advisers
- Asset allocation and risk management
And … discipline. Our job is to make you, the investor, a better investor and not to pretend that we can create better investments for you.
What’s really quite remarkable in the investment world is that people are playing a game which, in some sense, cannot be played.
There are so many people out there in the market; the idea that any single individual without extra information or extra market power can beat the market is extraordinarily unlikely. Yet the market is full of people who think they can do it and full of other people who believe them.
This is one of the great mysteries of finance: why do people believe they can do the impossible?
And why do others believe them?
Daniel Kahneman, Professor off Psychology and Public Affairs, Princeton University and 2002 Nobel Prize Winner