As a wealth advisor, a vital part of what I do is to understand – and deal with – a condition known as ‘behavioural investing’ – an awareness of the human biases that can often influence a client’s decision-making. Sometimes these biases are expressed quietly, even surreptitiously. On other occasions, they can be quite explosive.
Stephen Horan, head of Professional Education Content and Private Wealth for the prestigious CFA Institute, has this to say about the issue: ‘Most advisors have faced a situation where a client wants to change the strategic asset allocation of a portfolio during a period of great market stress. Behavioural investing allows advisors to better understand client behaviour and improve communication strategies in order to avoid poor decision-making and deepen client relationships.’
That’s the polite way of putting it. ‘We’re going down, Dave! We’re going down! What do we do now?’ is another, more extreme, version of the same thing.
Behavioural investing is a borderline pathology
Dr. Horan, in his paper Preventing mistakes with behavioural finance, identifies
several examples of this tendency (I hesitate to call it a ‘pathology’, tempting though that is) and here are just three of the most frequent:
- Loss aversion – where investors feel the pain of even small losses significantly more than the pleasure of equal, or even larger, gains.
- Recency effect – when you buy an investment based on its recent performance, you could be vulnerable to the tendency when making a decision to give recent events more weight than things further in the past.
- Herding – the pain of social exclusion for many clients is too great to bear, so the need to own the investment
flavour of the day prevails, win or lose.
All of these dispositions, and others I plan to write about, can have potentially disastrous consequences for the investor. As a result, I will explore the major ones – Morningstar identifies 10; there are more – in some detail in the next few weeks.
Even Keynes believed in it
Extraordinary Popular Delusions and the Madness of Crowds is a classic survey of crowd psychology written by Charles Mackay. Published originally in 1841, it is frequently cited by John Maynard Keynes as an influence on his work. And so it should be. Why we do what we do is a question most of us have difficulty answering for certain.
The consequences of unthinking behaviour results – more often than not – in misunderstanding and even regret. That observation made, few things in life are as brutal as losing money on an investment you are currently holding, or have lately acquired, for the wrong reasons. Stay tuned!
Dave Ritcey, The Ritcey Team, Scotia Wealth Management