An astonishing picture is emerging of the costly role of human errors in investing. Skilled and disciplined investors can use knowledge of these errors to their advantage.
Nobel prize-winning academics such as Richard Thaler and Daniel Kahneman have shown that deeply-ingrained behavioural biases - such as greed, fear, and overconfidence – drive most people’s investment decisions.
These errors cost the average investor between 1% and 4% a year in returns, according to studies. These percentages may sound small, but over the 20 to 40 years that most people save for retirement, they could become huge. Unchecked, simple human errors could therefore have a devastating impact on your retirement or other investment goals.
To demonstrate this, advisory educator Edvoa created a tool showing how behavioural mistakes can impact investments over longer periods. It calculates that for a £100,000 (€117,000) investment over 25 years these biases would cost an investor £85,000 (€99,000) based on a 1% annual cost of errors; or £191,000 (€223,000) based on 2%.
To use a real-life example, many investors were gripped by an irrational level of fear during the 2009 credit crunch and sold out of shares. If you had done that at the lowest point of the crash in March 2009, you would have missed the subsequent ten years of growth, which is over 60%.
Investors are mostly unaware of the mistakes they make, which can lead to perilously risky behaviour. For example, if you pick a fund that does well, you may think it is down to your skill, even if it is not. That may encourage you to take more risk next time. Conversely, you may become too risk-averse after a confidence-sapping failure.
Most people feel the pain of a failure twice as keenly as the pleasure of a gain, so they often become too cautious. That leads them to avoid investing in riskier assets such as shares completely, despite longstanding evidence that shares tend to provide much higher returns over the long term.
Another serious error is called sequencing risk, which is when people stay invested in risky assets up to the point they need the money, for example at retirement. This leaves them open to a market crash just before they need the money, which is potentially devastating.
Kahneman’s book Thinking fast and slow says psychological biases can be difficult to overcome because they evolved over thousands of years. Many are due to our tendency to look for patterns, which is necessary for hunting prey, but often highly counterproductive for complicated tasks such as investing.
Behavioural science shows that this pattern-seeking tendency has made us regularly prone to hundreds of biases, often too deeply-ingrained to overcome without removing the human from the process. A simple example is many investors’ irrational obsession with three- and five-year performance data. This short-term view often drives investment decisions. But academics have shown that managers usually need much longer to prove their strategies work consistently.
Behavioural biases do not just affect individuals – herd mentality often leads stockmarkets to behave irrationally, leading to crashes as seen during the credit crunch, and bubbles such as the dot com boom. A skilled and disciplined investor can potentially take advantage of this by selling when the crowd is greedy and overbuying; and buying cheap stocks in a falling market, when the herd is fearful.
One way individual investors can address these problems is to use a systematic approach based on academically proven principles. These principles include diversification across funds, sectors, asset classes, investment styles and geographies. Another is investing for the long-term and ignoring short-term volatility.
Alternatively, you could look for an experienced active manager who can use their skill, discipline and knowledge of behavioural finance to avoid cognitive errors, or even profit from irrational market movements.
Individual investors making their own decisions can also help avoid errors by asking for feedback – from a colleague, friend, or adviser. Some advisers are familiar with behavioural finance concepts and can help investors use a more structured and disciplined strategy.
A good approach is to plan investment strategies and stick to them; and rebalance asset classes automatically to keep within your targeted allocation and risk range.
Another is to only review your portfolio say once a year. This means you will see mostly positive movements and far fewer of the painful short-term drops that could prompt an irrational reaction.
To avoid sequencing risk, it is also important to start de-risking - by moving from shares into lower risk assets such bonds or cash - well before you need the money. This depends on several factors, however, such as how much you can afford to lose – a financial planner could advise on how much you need to derisk.
More adventurous and sophisticated investors might be able to further improve their decision-making process to identify market irrationalities when they happen and spot mispriced securities.
One way to do this is setting up rules that apply consistently to investment decisions and reduce the role of emotions. For example, you might set a rule to always sell a stock and take profits once it has risen 10%. One downside is that this approach can be painful for short periods, particularly when markets are behaving irrationally.
As with all these strategies, an experienced adviser or investment professional can help. But just being aware of cognitive biases is a good start in your journey towards more rational and more profitable investment.
Behavioral finance analysis has a central role in LGT Capital Partner's investment process, and goes far beyond the individual approaches discussed in this article. Some basic principles include:
These principles lead to the following rules: