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Behavioural Investing - November 2013

    CPD
    Approx.60min

    Introduction

    However, in the past 20 years or so, the concept of behavioural finance and its application to investment markets has brought to light the realisation that investing is actually about people and is therefore at the mercy of those people and their individual characteristics, idiosyncrasies and emotions.

    The people tend to fall into particular groups: those investing – privately or professionally; those running the investable companies; and those influencing the industry – so-called experts, whose opinions are relied upon to validate or reject our views.

    Ardevora partner Jeremy Lang underpins his investment process with behavioural psychology – taking the concept even deeper inside the mind.

    “It is about studying how people make decisions in the face of uncertainty – managing the balance between the two sides of the brain. The danger is that intuition lurks behind, masked by the more rational side of the brain, and it can start you off in the wrong place,” he says.

    Mr Lang explains that while the vast majority of behavioural psychology is non-finance related, there are certain parallels with other sectors in which it is used, such as construction or medicine.

    “The circumstances are usually complex, dealing with a lot of information, with back-end loaded risks – those where the repercussions are not immediate in terms of the risks you are taking. These are all environments that can lead to bad judgement.”

    The application of behavioural finance is founded in certain biases. Confirmation bias, optimism bias, loss aversion, hindsight bias, overreaction, overconfidence and herding are some common ones and having awareness of these biases can help investors avoid them.

    Tom Stevenson, Fidelity’s investment director, suggests the approach is rooted in the study of irrational behaviours and how they might be predicted in order for investors to benefit as a result.

    “Our brains have evolved over millennia to help us survive, but many of our behaviours are either survival or developmental. However these are not behaviours which translate into things that are ‘good’ investor behaviour.”

    Earlier this year the Financial Conduct Authority issued two papers on behavioural economics, with a clear interest in the area. Chief executive Martin Wheatley noted: “One of the most significant challenges for modern financial regulators and financial services alike is to recognise that we operate within a very human environment. A fallible world – not just of ratios and complex models but also responses, sometimes flawed, that behavioural economics helps us understand. There are questions that many investors simply will not ask because they are humans, not automatons.”

    Colin McLean, chief executive at SVM Asset Management, believes the approach is best used as a lens through which investors ought to scrutinise company reporting, results and data, enabling a thorough challenge of what is being presented –being aware that face value might not show the full picture.

    Although he warns against avoiding ‘herding’ for its own sake. In practice, Mr McLean believes wealth management, more so than fund management, can make better use of behaviour-based strategies, suggesting professional investors who have successfully adopted it in their businesses will keep records, checklists, understand their own weaknesses and develop rules around how to manage those in future.

    Allianz Global Investors’ Systematic Equity strategy portfolio manager Kunal Ghosh explains that to be successful at arbitraging human behaviour, each factor must be predictive, unemotional, repeatable and economically sound.

    He refers to a bias known as ‘anchoring the past’, where investors tend to shy away from stocks that have suffered recent losses, even when its future prospects might look promising.

    “It is not uncommon for investors to throw in the towel and say, ‘I would never buy that stock again’, based on the negative experience of losing money. Instead, our particular factor is constructed to capture improving fundamentals and curvature of the stock price, allowing for a better assessment into the changing sentiment.”

    Irrespective of the style of investing you favour, building even the subtlest framework around your emotions might help to keep your head when it feels like the shocks are against you.

    Sam Shaw is a freelance journalist

    In this special report

    CPD
    Approx.60min

    Please answer the six multiple choice questions below in order to bank your CPD. Multiple attempts are available until all questions are correctly answered.

    1. Which famous investor said behavioural finance investors aim to “profit from folly rather than participate in it”.

    2. Who is the current chief executive of the FCA?

    3. There are three approaches to behavioural investing - contrarian, value and what?

    4. Who is Daniel Kahneman?

    5. Who is behind the Minsky-Kindleberger taxonomy

    6. There are five stages of speculative stockmarket bubbles: Displacement, Credit creation, Euphoria, Financial distress and what?

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