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.