3 key psychological challenges for investors

What are the main challenges to achieving good long term returns? Investors focus mainly on what the stockmarket might do; less so on their own behaviour. Some of the human behaviour that confers advantage in everyday life can drive poor investment decisions. The big challenges include; how we search for patterns and trends, the desire to conform to social norms, and how we value the future.

The two main patterns behind poor decisions can be categorised as emotional biases and analysis errors. But these are often entwined, and emotion can even be part of very useful “gut feelings”. Fortunately, behavioural finance accepts the role of emotion in decision-making and does not simply demand that people just think harder. It offers some simple rules that can guide good investment practice.

One challenge stems from the natural human bias to see patterns in everything. It is a trait that typically gets worse as people age and they build up more experience. But, it is a shortcut that does not always work – sometimes patterns are perceived where none exist. Even where an underlying process is random, humans are naturally drawn to imposing order. We create stories and linkages that reassure us we can interpret events. It can encourage investors to jump aboard trends, and buy into shares too late. It is closely linked to the belief that we can understand complex matters by over-simplifying. That may give the illusion of controlling events that are actually more random than we think. Having an investment checklist or other analysis discipline can help to reduce the emotional appeal of patterns.

A recent survey of investment professionals highlighted social conformity – following the herd – as the biggest challenge. May professionals work in teams, which helps to explain this concern. This behaviour is often seen in committees or other small groups, where agreement is the easy option. But, what other people do can sometimes be a good guide when we do not understand what is going on. We tend to do this more when economic or company information seems to be changing rapidly, as in 2008. It can be a good guide in life – for example, picking the brand that gets most votes online, when they otherwise all seem the same.

But, that drive for conformity can make us slow to reappraise information, to think originally or even to take sufficient portfolio risk. Crowds can give false comfort. Investors should set rules on what might drive any change in their investments. It is important to clearly understand why an investment is held, and not be swayed by headlines. Similarly, jargon that often describes big companies or their chief executives may add little to investment judgement. How often do analysts tell us that a CEO is respected, the company is quality, and they have conviction in the share as a long term core holding based on fundamental analysis. It sounds good, but investors need to dig deeper.

There is also growing evidence that investors struggle to balance short and long term decisions. While we rely on the benefits of long term compounding of returns, it can be hard to evaluate what that really means in future. The short term wisdom of saving, or keeping costs and portfolio changes to a minimum, may not be recognised, because the results appear so far in the future. The real value of gaining big long term results from small decisions today is as much of a challenge in investing, as it is with diet and exercise.

Behavioural finance is changing the way that investment professionals think about their daily work. More financial advisers and wealth managers are now incorporating psychology into their advice. A good starting point is an investment plan that reduces stress, helping to avoid panic amidst stockmarket turmoil. And all investors should review their past investment decisions.

A version of this article was published in Personal Finance in The Herald on November 7 2015.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice. I am a manager of actively invested equity funds.

Image credit: Creative Commons Some rights reserved.