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How human instincts hurt us as investors

1 May 2018

Jamie Evans, business development manager flags some tell-tale signs and how to steer clients away from them.

The bull run is now the third longest since 1945, but the recent market turbulence has put many investors on edge, asking if this is the beginning of its end. However, when you step back and look at what’s happening in the world in terms of the fundamentals – the synchronised growth across most major economies and the improving earnings’ forecasts of the companies listed on stockmarkets – there doesn’t seem much to worry investors.  And while the bull run is longer than in some cycles, there isn’t an alarm clock set to go off and call the end.

So, aside from the concerns about the economy, what else could be driving investors’ concerns? We look into the some of the behavioural biases that investors are prone to and that you may recognise in some of your clients – understanding these could help your advice process.

Loss aversion
Otherwise known as ‘prevention focus’, people prefer to avoid losses to such an extent that they are willing to forego an equivalent gain. Losses are apparently twice as powerful emotionally as the gains and so the upside needs to be at least 2½ times higher before people will even consider an offer. This tendency comes through during the risk questionnaire and, as a result, your client may have ended up with a lower risk profile than they need to achieve their financial goals and aspirations.  All investments can go down as well as up, and their capital is at risk, but it might be worth having a conversation about goals risk i.e. not meeting retirement goals with your clients, in addition to the conversation about investment risk, and seeing if there could be a better balance between the two.

Recency bias
Volatility returned to the market in early February after an 18-month absence. Using the S&P 500 as an example, the second half of 2016 saw just 10 days in which the market moved by 1% or more and 2017 only saw 8 such days across the whole of the year. However, many investors seem to have forgotten that the current level of market movement is actually quite normal – a 1%+ move takes place on average 50 times a year i.e. about once a week.  Explaining that Q1 2016 saw 26 such days may help allay concerns that this volatility is the start of a bear market versus an opportunity to make changes to portfolios by buying on a dip.

Optimism bias
Akin to confirmation bias, where people only take in information that confirms their view of the world, those with a ‘glass half full’ approach to life have been duped into a very optimistic view of the world. They may see the gains of the last few years set to continue for the coming years rather than ensure that their assets are broadly diversified across asset classes. Optimism bias affects investors over the long term too. For example, older investors may expect higher returns from bonds than are now available.

Herding mentality
With today’s media scene, clients don’t even have to be part of a physical crowd in order to feel pressure from this natural instinct. Clients can react to press that links the recent news out of the technology sector to the dot.com bubble through to a fear of missing out from the cryptocurrency craze.  It can also mean though that they have positive or negative opinions on individual investments beyond any actual experience.

Familiarity bias
This is one of the most common biases that we come across and while most of the world’s economies are enjoying synchnonised growth, the UK because of the peculiarities caused by Brexit means that people should be looking to diversify beyond the UK more consistently – and yet we still find clients who have upwards of 80% of their assets invested in UK-domiciled assets. It’s simply because they feel more comfortable investing in a company or name that they recognise, but it can hurt portfolios given how Brexit is impacting multiple asset classes.

Anchoring
This is a behaviour often seen in times of market turbulence, where an asset’s price has come off recent record highs. The investor may have either bought in at that price or have fixed that value as the level at which they’d be willing to sell. However, what it does mean that they’ll be reluctant to sell, but may not have the stomach to go through the full cycle to see that investment seek to re-reach new highs over the long-term.

Availability bias
This instinct is effectively a mental shortcut for people to favour the information that they easily remember. The logic goes that if they can remember it then it must be more important than other information. This can mean that people are more easily swayed into investments that are well-known or the most traditional asset classes because their details are more easily recalled. It can also mean though that the latest news headline lodges in an investors’ mind and causes them to determine decisions based on that information alone rather than the full facts – which we’re confident that you can provide.

This list could go beyond the seven listed here – there are many more that warrant some attention. However, we hope we’ve covered some of the most usual and ones that you’re likely to come up against when advising investors and planning their future finances.

 

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