Your standard finance textbook gets it wrong, or at least doesn’t tell you the full story.
Three investors, three different paths of return this year (orange, green, blue). But assuming they start and end at the same point (I know they don’t quite), who feels best? And why? Which is the best investment?
Simple question with a complicated answer that soon reveals we aren’t the sort of rational creatures who could view a 1% return as a 1% return and leave it at that.
Greg Davies and other behavioral finance experts have been making this point for ages, while others like me are just catching up.
And this really matters because while the books, or the models might say that a 2% return is a 2% return, the fact that different PATHS to the same return are not-at-all equal in the mind of an investor is a hugely important thing.
Just some of the psychological effects that are going on when we’re on the sort of roller-coaster investment rides we’ve seen this year (see Greg Davies excellent piece for more):
- House-money effect (when we’re up we’re playing with “house money” and this feels good)
- Loss aversion – losses hit us harder than equivalent gains
- Regret/FOMO – we don’t like to miss out on gains
- Relief – we like to miss out on losses that others have suffered
- Relief (2) – we like to make back losses that we suffered
- Peak-end rule – our perception of an experience is dominated by the feeling at the end and the peak moment
- Re-enforcement – an initial positive feedback on a decision is powerful in re-enforcing our biases
- Receny bias – we put more emphasis on things that happened recently whether good or bad
So which of these effects will dominate? Well, that’s hard to say, it all comes down to personality which is why -as many people say- investment advice is as much about understanding the personality of your clients as it is knowing what the technically “right” model portfolio is. After all, if a client won’t hold onto your technically optimal solution, it isn’t worth much.
And I do think the same behaviors absolutely map through onto institutional investors and the groups, committees, and boards that make their decisions. It can be tempting to pretend that being professionals, and having committee meetings can counteract all these behavioral tendencies but my experience is that is absolutely not the case. Professional and institutional investors (and their advisers) need to take as much note of this as individuals.
In some cases our behavioral tendencies might push us toward a very sub-optimal portfolio, and there’s a clear role there for an adviser to try and nudge the investor away from that. But getting too hung up on what’s optimal is in my view the more common problem at the expense of what fits the investor behaviorally.
One of Greg’s central points is that we seek certainty and comfort and when it comes to our portfolio, if we don’t have these things we act in costly ways to acquire it, such as selling after a significant loss. This might seem theoretically suboptimal, but it may be very optimal if you are solving for your own peace of mind and fear of further loss. It’s difficult to counteract this, but understanding our own personality (or group tendencies) can go a long way to helping get ahead of this.
Time perceptive and temperament are really important here. Recency bias is rightly mentioned and I’ve sat in too many meetings where performance over the past quarter has been the first focus. Look at the long terms charts and you can’t even spot when most dramatic events were that impacted share prices. At times like this I find it incredibly useful to draw on some of the lessons that Charlie Munger, Warren Buffett (don’t write them off – size is now their disadvantage) and others tell us (through wide reading and watching) –
Buffett has talked about how when the price of burgers falls, the Buffett household likes to buy more – shares are one of the very few things that when they become cheaper, many want to ditch.
Munger (and his speeches are so worth reading!) has talked about the importance of “Invert, always invert” your thinking to overcome behavioural biases and noise. Buffett consistently uses the ‘20 choices in life’ and ‘only swing for the fat pitches’ analogy from baseball– if you were only allowed 20 choices in your life, you’d do your research and act with the probability of good reasoning, safety, confidence and success – patience is also critical. In Berkshire, Underwriters have been paid to do nothing for YEARS on end in the past in the reinsurance business – and then piling in when competitors suffer for chasing volume and pricing becomes favourable for Berkshire. Munger has said “Success means being very patient, but aggressive when it’s time”. It will be fascinating if Buffett largely sitting on the side-lines in 2020 yet proves to be enormously profitable long term (I can’t see how this is over yet).
No doubt, as in past events, 2020 has presented salivating opportunities – on a personal level, great investment trusts plunging to deep short term discounts to NAV, largely on the basis of supply and demand, only for those discounts to largely disappear plus share price appreciation on top of this. Good managers are considering the longer term – C T Fitzpatrick at Vulcan Value Partners is a good example, constantly thinking about the five year view – and there are others.
Times like this, I believe, can also be enormously favourable to well-run private companies – truly long term and not spending what can be 20-30%+ of their time having to explain themselves to public shareholders, whose turnover of share is at historic highs – we underestimate the sheer waste in the system.
So the journey is important, there’s opportunities along the way to massively increase returns if capital is available to buy on the dips. I get the rationale for portfolio rebalancing which also must come into this thinking on journeys to the same outcome, although am only 60% there as sticking with good when it’s fallen seems better than rebalancing to what seems a worse approach. I never owned Woodford (more people will have spent time researching buying a TV than going in to his fund), but the reallocation rationale on the journey would have had us shovelling money to him if he were in our portfolio. Back to Buffett and Munger who believe ‘risk is not knowing what you are doing’; hence massive concentration and patience and a superior result – which I appreciate is not the appetite of everyone.