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80-20 Investor  

With the summer almost over and the 'back to school' marketing messages in full swing, I think it's a good time to take a break from what is going on in investment markets and focus on a DIY investing lesson...

Investors spend a lot of time pondering where markets are headed and right now trying to discern when the current bull market will end is occupying a lot of grey matter. When deciding upon their next move investors might assess the current macro themes exerting influence on financial markets or the investment backdrop. They may even consider where we are in the economic cycle or price to earnings valuations. There's a myriad of things investors can and do look at in order to try and gain an edge and outperform the wider market. In the investment management world, this edge is usually referred to as 'alpha'. Alpha is a statistical measure of the added value that fund managers do or don't provide and can be useful in assessing whether their performance justifies the fees they charge. Yet the difference between the best and the worst managers can sometimes be pinned down to just one or two incorrect decisions, or even bad luck. Luck plays a part in investing whether we like to admit it or not. How much of a part it plays is difficult to quantify.

While you can't improve your luck you can improve your ability to make decisions. If we accept that the difference between successful and unsuccessful outcomes in investing has a lot to do with the decisions we make it, therefore, has a lot to do with how we think and behave as humans. More specifically it's how we overcome and deal with behavioural biases which influence whether we make good or bad investment decisions. In simple terms, our tendency to make emotional decisions when investing clouds our judgement. It stops us thinking clearly and hinders our ability to assess facts to arrive at a reasoned decision. For DIY investors, in particular, this is an issue as they are investing their life savings. Money that they are emotionally attached to.

In theory, things should be easier for investment professionals who are investing other people's money. People who they have never met and never will. Unfortunately, this detachment often leads to professional investors chasing performance and becoming increasingly reckless, which in turn means they are prone to making bad decisions.

If we want to improve our chances of making better investment decisions we need to understand how and why we make decisions, especially those concerning money. Why did people wade into the bitcoin bubble? Why have the equity market bears been sat on the sidelines for the last 9 years scolding those investors who invested in the stock market and who are now sitting on considerable profits?

The truth is that the way we behave and make decisions can be boiled down to the fact that we are human and evolution has made us bad investors. 

Our brains are essentially supercomputers that can process and recall information at incredible speeds. When we are born this supercomputer needs to be programmed. Everything has to be learnt. All this experience and learning helps inform our future decisions in scenarios we've never experienced. Over time our brain learns to create shortcuts, rather than evaluating every situation we encounter as if it was unique. It frees our brain to be able to do other things. It's why we can drive a car from A to B almost subconsciously while holding a conversation with the person in the passenger seat. It also means that we are able to make decisions from imperfect information.

While this is ability has huge advantages it has its drawbacks. It means we have behavioural biases which can cause us to make the wrong or illogical decisions, even if we are presented with perfect information. It's these behavioural biases which make us inherently bad investors. It's not the market that is our worst enemy, or Trump's tweets, or the trade war but ourselves. One way to improve our chances of outperforming the market is to accept our biases and try to counter them. 

Depending on which study you read it's claimed that there are as many as 100 behavioural biases which vary from person to person. Some of the key ones from an investment perspective include:

  • confirmation bias
  • loss aversion
  • anchoring
  • fear of missing out
  • overconfidence
  • self-attribution
Behavioural biases are like shadows, they are always there. If we want to improve our decision making we need to shine a light on them in order to banish them. Below I look at some of the key behavioural biases, how they affect our investment decisions and how to counter them.

Confirmation bias - is the tendency for investors to put more faith in information that agrees with what they already believe and to ignore opinions and data that disagree with this belief. Confirmation bias even means that we tend to more easily recall things that reaffirm our belief over those things that don't. You may think that you would never do such a thing but I want to prove that you too can't help but fall foul of it. Just watch this short entertaining youtube video of an experiment into the power of confirmation bias. It's called Can you solve this? See if you can work out the answer before those in the video do. The odds are stacked against you, simply because of your human nature.

The problem is that confirmation bias is so powerful. That's why investment markets can detach themselves from fundamentals and form bubbles. Bitcoin mania was a good example of this. If you combine confirmation bias with our tendency to make emotional decisions (based on fear and greed) it is a lethal combination when it comes to investing. It is also why people won't admit when they are wrong and will hold on to losing investments for too long, firm in their belief that a bounce is imminent.

How to counter confirmation bias: always seek the opposite view to the one you currently hold. So don't just read articles about why the stock market is set to collapse. Seek balanced and well-researched articles that claim the opposite. When the market collapses don't just read articles telling you that a rebound is imminent. Seek balance.

Loss aversion - describes investors' preference to avoid losses over making gains of an equivalent size. In fact, it's claimed that the pain from losses is twice as powerful as the joy from making gains. It means that investors will tend to avoid risk, stick to the status quo and hang on to losers. Fear becomes the main driver and indecision and inaction can mean that you end up regretting missed opportunities or being stuck in tumbling investments.

How to counter loss aversion: when the market is at or near all-time highs loss aversion can end up paralysing new investors. That's why it is particularly relevant in the current market. Sticking to a process is often the best way to counter behavioural biases. In this instance, new investors should drip their money into the market if they are worried about it falling. That way they benefit from pound-cost averaging should the market tumble. For existing investors, they should try and view their portfolio without reference to the price point at which they entered the market. Focusing on the price at which you bought an investment is another behavioural bias known as anchoring.

Anchoring - is when our exposure to a number ahead of a question being asked influences our answers. In terms of investing that number can be the price at which you bought a fund or share. That number then takes on increased importance and will often influence whether investors decide to sell or keep an investment. Behavioural biases can work together to cloud our judgement, and not just in isolation. Our bias towards loss aversion when combined with anchoring means that investors will hold on to losing investments for too long. 

How to counter anchoring: rather than focusing on the price you bought at (i.e. the profit/loss) instead focus on whether, given the current information available, the investment represents a better or worse option than an alternative. This will mean that you will make the decision of whether to keep the investment without the emotional pulls from loss aversion and anchoring. You will notice that when I review my own £50,000 portfolio I never reference the starting price at which I bought a fund. I never focus on the profit/loss when making a decision. Occasionally I may show a chart highlighting whether a fund choice was profitable or not but principally I do this to demonstrate that I do sell funds at a loss as well as a profit. By sticking to a process I avoid the paralysis caused by anchoring and risk aversion. Of course, selling a fund at a loss is not ideal but it is important to accept that you won't get every investment decision right. Be humble. The aim is to get more right than you get wrong. Simply being wrong is usually not the problem, it's the not accepting that you are which gets you in trouble and loses you the most money.

Overconfidence and self-attribution - although two separate biases they work closely together. While overconfidence is fairly self-explanatory (i.e our belief in our ability exceeds our actual ability which leads us to become increasingly reckless) self-attribution may be less familiar. Self-attribution bias is our tendency to attribute successes to personal skill and failures to factors beyond our control. So when the market rallies and your portfolio performs well you claim the reason is your genius. When the market falls you blame Trump or the central banks or other investors for selling out and sending the market lower. Of course, there will be times when your outcome is a result of a particular call that you made. However, self-attribution tends to lead to overconfidence which ultimately leads to increased risk-taking. It can also mean that you don't evaluate your past successes and failures leaving you open to repeating the same mistakes. It also means that you don't acknowledge how much luck (good and bad) plays a role in investing. 

How to counter overconfidence and self-attribution: always be humble. There's nothing wrong with acknowledging your successes but also try and acknowledge your failures. Sticking to an investment process (whichever one you choose) helps counter both biases. In the case of 80-20 Investor this is a process based upon momentum and regularly reviewing your portfolio. By acknowledging and accepting how a process works counters our tendency towards overconfidence and self-attribution. It's one of the reasons why I also emphasise that when markets fall so will a momentum based strategy. The ups and downs are dependent on the market. 

Fear of missing out (FOMO) - is a powerful bias which is as much about greed as it is about fear. It's the reason why bubbles inflate exponentially in the latter stages before bursting, just as bitcoin did. It can lead to rash investment decisions based almost exclusively on emotion. 

How to counter FOMO: much of the fuel for FOMO is social media and sensationalist headlines. When you have a conversation about an investment with someone (perhaps down the pub) who ordinarily has no interest in investing you know FOMO is driving the market. Bitcoin was a classic example. One way to overcome FOMO is to seek the counter viewpoint to give balance. Alternatively, switch off social media and ignore sensationalist headlines altogether. Also by acknowledging and accepting that you could miss out it removes the fear that can drive you into taking action that you might regret. Remind yourself that you are investing, rather than speculating. The former is 'get rich slowly' while the latter is 'get rich quick'. We all know that get rich quick schemes seldom work. Objectively assess the risks vs the rewards of an investment. Is there a reliable process investors are following? If you realise that FOMO is starting to cloud your judgement look to those who are doing the cheerleading and see if you can recognise behavioural biases in them. Often you will see overconfidence and self-attribution. As the saying goes it is better to be humble at a market high rather than be humbled by a market low. It's no coincidence that many traders are also compulsive gamblers in their spare time. The next time you are tempted by a once in a lifetime opportunity to make huge profits by 'buying into a particular investment' then stop and think how you would have reacted if you were offered a once in a lifetime opportunity to make huge profits by 'backing a particular horse'. It's no different.

By acknowledging our inherent biases, such as those above, and taking steps to counter them it can help us make better investment decisions. Of course, it doesn't guarantee they will always be profitable decisions but it should increase your chances of success. Studies have shown that if you focus on process it leads to better decisions. This is also true in investing. Focusing on process (momentum or otherwise) frees us from worrying about the things we don't have control over. That's not to say you won't have periods of underperformance, every sound process will have. It's why computers don't consistently outperform the market either.

Ironically if we are just a bit more self-aware of our own biases it means we are more likely to profit from other people's. Perhaps this was best encapsulated by Warren Buffett, arguably the most successful investor of all time who said be “fearful when others are greedy and greedy when others are fearful.” 

Why do most people not take heed of his advice? It's because we are only human.
 

Data Update


As it is the start of a new month I will publish a new Best of the Best selection and update the Best Funds by Sector table on 4th September.

Best Wishes
 
Damien Fahy
80-20 Investor & MoneytotheMasses.com founder

Damien is regularly quoted in the national press including:
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