Are you a naturally skilled investor? Almost certainly not, says Dr Peter Brooks, head of behavioural finance at Barclays Wealth and Investment Management. According to the former academic, we all instinctively lean towards bad, or even damaging, investor behaviour, so the only way to make serious money is to fight against your human instinct.
"Our psychology is wired to make us the opposite of good investors," says Dr Brooks, who claims that emotional investing can lose clients up to 3 per cent a year. He was hired in 2007 to explore the ways clients could overcome their biases and instinctive behaviours to make more money.
Behavioural finance shot into public consciousness two years ago when the government set up a 'Nudge Unit' to examine how people make decisions, and attempt to shift their behaviour by presenting choices in slightly different ways. For example, if you send road tax reminders to people with pictures of their cars, they are more likely to pay. By gently exploiting common psychological traits, the government found it was able to 'nudge' people towards better behaviour. Now it has been embedded into a bank near you.
Barclays' behavioural finance team looks at the ways nervousness, fear or overconfidence can cause people to buy and sell at the wrong times, and the way the bank can communicate differently with investors to limit those emotions.
"Consider market cycles, for example," says Mr Brooks. "People become more excited when markets are rising, and grow more fearful when markets are falling, and their expectations shift. If markets are rising and funds are making excellent returns then you are already late to the game, yet return perceptions have increased and risk perceptions have gone down. Objectively, the opposite is the case. When you get to the bottom of the market, risk feels high - but objectively, it is lower than at the top."
How your emotions are costing you returns
According to a Barclays report: "Financial decisions that are optimal for the long term are often very uncomfortable to live with in the short term. In turbulent times, theory often goes out the window. Depending on the market cycle and how it makes us feel, we may leave large portions of our wealth uninvested; we may be overconfident and overactive with the portion that we do invest; and, in the end, we often give in to our strong psychological tendency to buy high and sell low."
The bank uses several behavioural economics theories to address investor behaviour. The behaviour gap is the gap between emotional reactions to the market and rational decision-making, and the associated cost.
The disposition affect and loss aversion explains a key reason for buying high and selling low: Our fear of losing. Investors are unwilling to convert losses by selling losing stocks and far more likely to realise profits, even when it is less rational to do so.
Anchoring and framing "are also very common behaviours", according to Dr Brooks. "Investors will frequently mentally anchor on a purchase price for a stock, which results in a red or green number on a screen when that price rises or falls, and creates anxiety. People focus on the past and anchor on specific points in time too, which explains why they obsess about market highs and lows. The better way to think is: if I didn't have that anchor price in my mind, would I still want to hold that stock today?"
Overcoming your emotions
Mr Brooks says there are two ways Barclays uses behavioural finance: in a paternalistic way, to communicate differently with nervous clients, and by teaching investors about their own biases.
The key to the latter is the bank's financial personality assessment, a test designed to tell investors about their own biases and triggers for making investment decisions. It gives information not only about risk tolerance but also about your composure, which gives investors a sense of how stressed external events might make them. By working out your own financial personality, he says, you can attempt to override your common emotional triggers and teach yourself to be more disciplined.
Another way to override your emotions is by continuously coming back to your original investment case for a stock or fund. "Think about whether newsflow actually changes your original investment case," says Dr Brooks. "You should be constantly appraising the case for holding something."
One way to do this could be by writing an investment journal, listing your reasoning for buying or not buying certain things. This kind of discipline forces you to return to objective facts instead of getting carried away in market hype.
"Overcoming the disposition effect is really hard because performance is backwards looking," explains Dr Brooks. "One way to reduce the anxiety associated with individual holdings is to look at performance on a portfolio level rather than always looking at specific stock performance."
Dr Brooks says the bank nudges some clients away from certain behaviours by actively changing what they see and hear. So in some cases the answer to customer nervousness is to reduce the regularity of financial statements.
He says: "Depending on their financial personalities, you might make sure that certain clients are the first people you communicate with after a market crash. For other people, you might simply reduce their statement frequency" - a form of ignorance is bliss.
| Peter Brooks CV Dr Peter Brooks is head of behavioural finance at Barclays. He joined the company in 2007 and co-developed, launched and implemented Barclays Wealth and Investment Management's investment philosophy. He has also worked as a senior research associate in behavioural and experimental economics at the University of East Anglia. His research here involved designing and running experiments in to whether repeated market outcomes and experiences teach individuals to overcome psychological biases. Dr Brooks holds an MSc in economics and econometrics, and a PhD in behavioural and experimental economics from the University of Manchester. |
