We all like to think we are rational investors, but how close is this to the truth? Investor Coach Jane Coffey reveals to Alfred Rinaldi how emotions play a bigger role than we think.
When it comes to investing, we like to think that we are perfectly rational agents, dispassionately analysing each position on its merits in a market that perfectly reflects all available information in its prices.
Comforting though this classical world-view may be, it’s far from the truth. If investors are so cool-headed, how to explain those bouts of “irrational exuberance”, which have occurred since from the 17th-century Tulip Mania right up to the sub-prime mortgage boom and bust? According to Jane Coffey, Investor Coach and Head of Equities at RLAM, such market anomalies can only occur because investors are led by emotions and biases at the expense of the underlying facts. And the solution, according to her, is to admit we’re all emotional animals. Once we acknowledge our limitations, we can deal with them – and so let reason enter.
Good investing feels terrible
“We do what feels good rather than what is good”, explains Jane cheerfully. “The basic theory of investment should be buy low, sell high. That feels terrible. When you’re buying low, you are buying when everything around you is telling you that this is really dangerous, because there’s lots of negative news around the investment. When, on the other hand, you buy the fund that’s done best in the market, you feel great, but actually, chances are you’re buying high instead of low. Understanding this emotion and refocusing on the underlying rationale for an investment decision helps us overcome this handicap, and that’s what Behavioural Investment is all about.”
The key to understanding why we act in different ways lies in the study of the human brain. Far from being a homogenous thinking machine, our brains consist of three parts. The oldest part is the reptile brain, which makes instant decisions based on instinct and reflex: fight or flight. The mammalian brain can feel and process emotions such as joy, anger and fear. Finally, the rational brain has self-awareness and can solve abstract logical problems.
According to Nobel-winning economist Daniel Kahneman, this results in two thinking systems: System 1 – instinctive and emotional – is fast, and System 2 – rational and logical – is slow. The trick is to train ourselves to use System 2 when investing.
“It’s not a question of good versus bad”, says Jane. “We need fast thinking and emotions. If we had to painstakingly weigh up every single decision we make, we would not get very far.
But when it comes to investing, emotions are undermining rational thought. So if you can recognise what your emotions and biases are, then you can look at ways to stop them influencing you in a negative way.
Even highly intelligent investors can be fooled by feelings: “IQ does not protect against investment losses”, explains Jane. “Isaac Newton invested a bit in South Sea Stock and exited the market happy, having doubled his investment. But then the stock rose even further. Newton saw his friends get rich as the bubble expanded. Newton re-entered with a lot, the bubble burst and Newton exited broke.”
For the rest of the great physicist’s life, no-one in his presence was allowed to utter the words “South Sea”.
The same irrational tendency is clearly visible in years when stocks go down. “People don’t take their ISA allowance when markets are falling – which is exactly what they should do. Instead, this is when you see the biggest outflows from equity funds”, says Coffey.
“The challenge for a private investors is to overrule the uncomfortable-ness when equities are very volatile and have gone down a lot, realising that the biggest danger they face long-term is that they sit in cash for way too long.”
Awareness is the key
“To be a good investor, you have to be conscious of the process. Keeping an investment journal helps. Record why you buy or sell a position, then review what happens. That way, you can identify your biases and incorporate learnings into your process. The herd instinct is a powerful bias. To counter that, instead if looking at the market, look at a stock’s intrinsic value – its price to book or price to earnings. Then, periodically review your decisions: when the facts change, the decision should change.
The reason why people hang on to stock that should be sold is because we don’t want to feel the pain of realising a loss. Losses are felt more keenly than gains: this ‘loss aversion’ is an emotional bias that can keep investors trapped. A stop-loss rule of say 10% can help to force a review.”
“This is not to say we should be quick to sell. Overtrading is costly and has an impact on performance. Generally, the less trading you do, the better.”
Similar rules apply to more detached investors, who entrust their money to a fund manager.
“Investors usually invest for the long-term, yet short-term oscillations in their investments scare them more than they should. That’s because we have a natural tendency to focus on the short term known as the ‘recency bias’. The trick is to overcome this uncomfortableness and realise that the longer-term you are, the safer it is to be in the market. The facts are that it’s been impossible to lose money over any 10-year period over the last 100 years. So the thing is to consciously counter this fear of ups and downs by keeping your eyes on the horizon.”
Pound-cost averaging is another simple but effective strategy to overrule emotions and biases. By investing a set amount each month no matter what, investors can take advantage of the troughs, when prices are cheap, as well as enjoying the feel-good factor of investing when the market is doing well (but unit cost is high). Over the long-term, investors reap the stock market’s risk premium.
“Likewise, instead of demanding that investment managers follow the herd, allow them to stay the course even when the market is behaving irrationally. Remind yourself, this behaviour is what I expect from a financial manager, and this is how I should react to it.”
This is all very well, but keeping one’s own biases and emotions in check is difficult. Professional investors are governed by rules designed to counteract biases, and regularly challenge each other on their decisions in a spirit of helping each other eliminate emotional blind spots.
As individual investors, we have to do without such institutional support. Instead, we may be subject to advice from friends and family which exacerbates rather than reins in our emotional and biased responses.
For those who’d like a qualified sounding board for their decisions, Jane offers bespoke investor coaching: it’s a service that’s designed to identify patterns in people’s mistakes and suggest improvements. Every once in a while, she gathers a group of avid investors to a luxury villa in Italy or the Caribbean, where she offers Physical and Financial Fitness retreats partnering with a fitness instructor.
“Even without a coach, you can use structures and strategies to get a rational overview of emotional reactions.
Use the data in your journal to look at what you have done. Why did you buy something? What happened? Would you make the same investment today?
Looking to the future, there is a temptation to seek comfort in complex forecasts and models. But ultimately, we all make assumptions about the future, so it makes sense to be conscious of what they are, and test them. To which degree are these assumptions based on our personal traits? Bringing the subconscious into the conscious, we can act more rationally.”
Thinking so much about how irrational we all are, shouldn’t that deter us from putting our money into a market so prone to misjudgement?
“Not at all”, says Jane. “It depends on whether you look at short term ups and downs or the long haul. Benjamin Graham, the father of value investing, put it very well: in the short run, the market is a voting machine – but in the long run, it is a weighing machine.”
So, the system is not so mad after all? That feels quite reassuring.