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Psychoanalysis for a better portfolio

'On the couch' scrutiny can make you a better investor
Psychoanalysis for a better portfolio
  • Rules and asset allocation are a star to steer by
  • Too many investors start out trying to copy Warren Buffett

Subjecting investing personality traits to scrutiny can feel like a form of therapy. Picking through the behavioural ticks that affect decision-making is emotionally challenging, as I found when I asked an expert to study my beginner portfolio and processes.

“Merely the fact you are exposing [your] decision-making to probing and testing puts you head and shoulders above the vast majority of investors out there.” Those were the reassuring words of Dr Greg B Davies, Head of Behavioural Finance at Oxford Risk.

Opening with positive feedback in itself demonstrates an optimism bias and the way human beings cling to comfort. Listening back to Dr Davies’ feedback and transcribing his words, however, it struck me that I have been lazy, over-confident and arrogant and that’s costing me money.

It’s easy to beat yourself up, too. Which brings us to the first point of the lesson I was given: always get things written down. In conversation I was in the denial phase, my brain was trying to seize slices of comfort to justify what I’d done. Listening again I focused on passages where I’d sounded foolish. It was only reading a list of points when perspective could be found.

Going back over all Davies’ feedback the true balance of opinions was there in black and white. There are pluses and minuses I can run through dispassionately rather than focus on what made me feel best or worst, skewing my perception of the overall message.


Making the investing process as robust as possible

Anywhere you can take the emotion our of investing is good, but that doesn’t necessarily mean we should all just buy tracker funds. What Davies describes as “brute force diversification” is the best way for many people to ensure the best risk-to-reward trade-offs in their portfolios. Still, for investors with the time to bring discipline to bear, conviction earned by hard work can bring rewards. Warren Buffett is proof of that.

Investing should start with an objective and while I’m focusing on my good points, one is being long-term in outlook. “[There is] really only one sort of good investor which is a long-term investor. Anything else is an oxymoron,” says Davies.

The other thing I do well is having a strategic asset allocation (the mix of shares, bonds, and other assets), which Davies describes as a “star to steer by”. I’ve also taken steps to set myself rules on the size of positions I hold and of transactions that I’ll make.

So, having rewarded myself by recounting praise, what could I be doing better? For the portion of my portfolio invested in equities, I’m looking to achieve diversification by investing in different themes that interest me. This is still far more concentrated approach than investing in a tracker to buy global shares and the first question is whether my fund selection is robust enough.

I’m telling myself that “I like thematic investing because the stories can explain to myself and other people why that’s a good idea. It buys me emotional comfort.”, explains Davies, voicing my thought processes in the first person.

That’s one of three ways he says I build narratives to make me feel good about decisions.

Firstly, I’ve bought into investing themes such as clean energy, the so-called mining super-cycle and the rise of Asia based on recent history. In other words, I’ve anchored expectations to good performance last year.

I was aware of this first flaw and that I had missed upside but my second framing bias, was to focus on the stories behind the funds more than a fundamental-led analysis. As Davies said to me “risk-reward trade-offs don’t bring comfort. Stories do.”  

Thirdly, my love of narratives is also in part because of how I like to see myself as a person. For example, investing in green energy makes me feel progressive and garners approval from my peers, another emotional comfort factor for decision making.

Davies’ honest judgement is that my fund selections are based on convictions that are “not properly researched and justifiable.” Ouch.

Hearing those words, my first reaction was a bit defensive, but Dr Davies is right.  Having taken the first step of setting a strategic asset allocation and creating some rules about position management and transactions, I must be honest about where I sit on the spectrum of investors.

For those of us with either little time or little expertise, Davies suggests we should impose rules of brute force diversification. In practice this means buying trackers and relying on beta (the portion of returns due to the moves of the market as a whole). The disadvantage of this is buying bad shares with good ones, but if you’re pushed for time or you don’t know what you’re doing, it’s the cheapest way to get the market level of reward-to-risk from owning shares.

Alternatively, you have great investors like Warren Buffett who through time, effort and skill can pick stocks that give them a better reward-to-risk than the market. One very common mistake, says Davies, is that most investors start out thinking they can go in at the Buffett end of the spectrum when they ought to start nearer the brute force diversification end.

Knowing that picking individual shares is difficult I have preferred to get my equity exposure through funds. Also, not having enough money to invest decent position sizes in lots of companies, getting diversification by myself isn’t cost efficient.

There is still picking involved in buying themes, however. Looking at underlying holdings, crunching the numbers, and making an informed decision on whether the fund is good value is as important as assessing an individual stock. If you don’t have time then there is an argument for going for more passive investments.

Cost provides another compelling reason to do so. As Davies pointed out to me, many of my funds charge anywhere from 65 to 100 basis points or more (or 0.65 to 1 per cent), whereas an MSCI World index tracker would cost about 50bps a year to own.  

The impact of charges isn’t a revelation to me, but knowledge is nothing without action. There is some truth to Davies’ observation that I looked to emotional justifications to push myself to get invested in the first place, hence the thematic bias.

In one respect I needed the endowment effect of investing in ‘my’ ideas to get me going. It made me far more engaged than buying a tracker. That’s a good thing as even with my relatively weak portfolio performance in 2021 (only up 1.8 per cent net of charges between the ends of January and September), I’ve still done better than had I kept my money in cash.

Still, given I invested a lump of cash at the outset, arguably I would have been better off buying a diverse tracker as a core holding in equities. Then I could have built in my themes at the margin. This would have given me a broad exposure and taken the time pressure to diversify off my watchlist of ideas.

Taking time to do more groundwork on the watchlist and adding in checks and rules will help me rank the most attractive. My decision on which to buy first should be based on conviction earned by research and a systematic analysis of valuation.

Any way I can lengthen my deliberation and subject it to rules will help. “Bake good behaviour into a system and it removes a large part of the emotional component of a decision,” counsels Davies.


Adding to my written investment constitution

Continuously enhancing my process is important, as is not transgressing the rules. Rules can be changed but gradually, and never to shoe-horn investments into the portfolio on a whim.  

When it comes to improving what I’ve already done, the focus shouldn’t be chopping and changing holdings and incurring charges. My endowment effect and the loss aversion I exhibit (by keeping underperforming investments hoping they’ll recover) are cognitive dissonances I can allow to “run wild” in Davies’ view.  

As I’m in the accumulation phase of investing and have a long timeframe, what’s more important is how I begin to alter my thought processes before buying again. When I have the cash set aside to add my next holding, it must be selected from a few options that have all been reviewed on a scorecard of criteria: growth prospects, the financial quality of underlying holdings, valuation, and impact investing to name a few.

I’ll also need to display the humility to seek alternative views to my own. Some of the narratives I set store by have taken a battering in recent weeks. The commodities super-cycle argument is undermined by the precariousness of China’s real estate market and debt bubble; and the transitional drawbacks for green energy are exposed by global energy supply issues and price volatility. These arguments aren’t new, it’s just they didn’t fit my narrative when I bought.

Being in a reflective and psychoanalytic mood, I’m reminded of the famous split screen scene from the Woody Allen film Annie Hall. When quizzed by their psychiatrists, Allen and Annie (played by Diane Keaton) offer totally different interpretations of their relationship, even though they agree on the details. Perhaps neither of their truths is totally right but for the film viewer seeing both sides simultaneously is important.

It's the same with an investment case. Playing Devil’s advocate with portfolio decisions could certainly save investors like me heartache.


See also: Good portfolio advice can be hard to take