How our brains lose us money

One of the most striking things I’ve witnessed during three decades of observing investment markets is how investors tend to do the opposite of what works.
 
Prior to the Global Financial Crisis when stocks were expensive, everyone was piling in. After the crash when they were cheap, they were selling (which is of course why stocks were cheap). That pattern is repeated throughout history. As much as we might recognise it, somehow it never changes.
 
It’s odd when you think about it. In every other area of our lives we tend to buy more of something when prices fall and less when they rise. Why is the sharemarket different?
 
Research house Dalbar’s long-standing Quantitative Analysis of Investor Behaviour1 research shows that US investors continually fail to beat the market (see chart below), a proposition supported by  other studies, including The Behaviour of Individual Investors2 by Brad Barber of the University of California and Trading is Hazardous to Your Wealth3 by Barber and Odean.
IPOT

None of this should surprise us. Ben Graham, known as the founder of modern investing, once said, “the investor’s chief problem – and even his worst enemy – is likely to be himself”. Behavioural economics, which applies psychological insights to human behaviour to explain economic decision-making, explains why that’s the case.

Since the 1960s, some of the best and brightest minds of our time, including William Goetzman, Robert Schiller, Ward Edwards, Amos Tversky and Daniel Kahneman, undertook research that revealed the irrationality in our decision making. This is the reason why so many investors fail to beat the index.

First, we’re over-confident, with an inherent inability to acknowledge the full extent of our ignorance and the range of possible outcomes of decision. This means we tend to pay high prices for stocks, especially those with rising share prices. Then, when reality intervenes and share prices fall, that optimism turns to fear and we sell out at the worst possible time.

Secondly, this tendency is exacerbated by our herd instincts. To take advantage of cheap prices and avoid high priced assets inevitably involves going against the crowd, and that’s something humans find challenging. We like safety in numbers. But in investing, that tendency can bring us undone.

To overcome it requires deeper information than most retail investors are prepared to dig up and a mental approach driven by rational, probabilistic thinking rather than the emotionally-driven decision making unwittingly employed by many investors. And that’s far easier to say than it is to do.

We also have what Kahneman and Tversky called a bias towards loss aversion: we much prefer to avoid losses than acquire gains, which is why so many of us sell out when a share price or unit price in a managed fund falls, meaning we miss out on the subsequent gains.

All of which is to say investing isn’t easy. And, because humans tend to learn through personal experience rather than, say, reading stuff like this, we usually need to lose money to improve at it.

That poses investors with a conundrum. If you’re not prepared to invest the time and exercise the discipline required to overcome the psychological biases from which we all suffer, and you aren’t prepared to lose some money along the way, are you the best person to be managing your money?

We can all be irrational. Making investment decisions on your own without rigorous peer review, nor many decades spent over-coming our inherent biases, is a sure way of achieving a poor result.

What’s the alternative? Let me wheel in my own particular barrow. I’m a career fund manager that has only ever worked in property. I’m part of a large and diverse team that, combined, has over 68 years managing diverse portfolios of property related assets. When investors delegate their decisions to us, they get a team of experts empowered to challenge each other to achieve superior performance.

We pool funds from like-minded investors to deliver a reliable income from property that, at least according to our performance track record, appears to make sense. By avoiding excessive risk (from non-property rent sources like property development or funds management) we can obviate many of the classic risks in decision making so clearly explained by behavioural economics.

By keeping a simple focus on income, not promising excessive upside and explicitly managing for the downside, we minimise the impact of the adverse human traits that undermine performance. Of course, we charge for the privilege of managing your money. But if you’ve ever succumbed to herd instinct, overconfidence or emotionally-driven decision making, you’ll know the value of it. Over to you.

This article has been prepared by APN Funds Management Limited (ACN 080 674 479, AFSL No. 237500) for general information purposes only and without taking your objectives, financial situation or needs into account. To receive further updates and insights from the APN team, sign up for Review, our monthly email newsletter.

  1. DALBAR research 2016, via Real Investment Advice
  2. https://www.umass.edu/preferen/You%20Must%20Read%20This/Barber-Odean%202011.pdf
  3. http://faculty.haas.berkeley.edu/odean/papers%20current%20version/individual_investor_performance_final.pdf