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As investors, we have to contend not only with the erratic and unpredictable nature of markets but also the erratic and irrational way in which we think and behave.  A lack of knowledge, combined with a number of illusions and biases can lead to errors in making decisions that can turn out to be very costly.  Some of the common behavioural traps – and how to avoid them – are set out below:

Trap 1: Believing you are better than average

Human beings tend to be overconfident in their abilities. For example, out of 600 professional fund managers asked in a study almost three quarters said they were better than average.

Mitigation strategy: Have some humility – plenty of very clever people get beaten-up by the markets.

Trap 2: Mistaking random noise for patterns

A rational gambler playing roulette knows that the chance of any number coming up is the same as any other number.  Yet, a sequence of three red ‘9s’ in a row, can create quite a stir at the table.

Mitigation strategy: If you detect a pattern in shorter-term data it is probably meaningless.

Trap 3: Problems with probability (and maths in general)

For example, many people are willing to pay more for something that improves the probability from 95% to 99% than from 45% to 49%, despite the financial benefit being the same.  Virtually no one can compound in their heads.

Mitigation strategy: Do not ignore the maths.  Sit down and spend a little time teasing out the numbers.

Trap 4: The Monday morning quarter-back – hindsight delusion

With hindsight we often honestly think we could have predicted what has happened, such as a fall in the markets.  The evidence suggests that we cannot.

Mitigation strategy: Do not believe that you have predictive powers – it is unlikely that you do.

Trap 5: I will throw my anchor out here thanks

The human mind really likes to use mental ‘anchors’ when forming opinions, which in many cases leads to extraordinarily inaccurate estimates of outcomes.  The level of the FTSE 100 is a common investment anchor for clients, even if their investment portfolio is very different.

Mitigation strategy: Do not allow yourself to get hooked on meaningless anchors.

Trap 6: It is more familiar to me, and I get it

Humans tend to make spontaneous generalisations, based on how they are influenced by recent events, press coverage, their own experiences, and the vividness with which a situation is portrayed.

Mitigation strategy: Stand back and seek a broader perspective.

Trap 7: I like a good story

We all love a good story and there are few better story-tellers than fund managers.  The danger is that the narrative of a plausible sounding script, often full of contingent probabilities, tends to persuade us to assign a higher likelihood to the story coming true than is realistic.

Mitigation strategy: Be a sceptic – take everything you hear or read from the industry with a pinch of salt.

Trap 8: Short-termism and obsessive portfolio monitoring

Many investors find it difficult to see the long-term wood for the short-term trees. Their focus tends to be on the effects of recent market conditions on their wealth and this affects their ability to make good decisions for the long-term success in meeting their lifetime purchasing power needs.

Mitigation strategy: Given the 2:1 ratio of pain to gain, the longer the period between peeks at a portfolio the better!

The solution: process, process, process.

Investing using a well thought-out, evidence-based and systematic investment process helps to take much of the emotion out of investing.  A good process won’t always deliver a good outcome, but over time it raises the chances of one.  While investing is simple, it is never easy, largely because of how we behave.

Other notes and risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

We tend to regard wealth as financial assets, large houses, and nice cars accumulated through a life of hard work.  Yet that is to view wealth in narrow terms; on the very day we are born we are wealthy in terms of our human capital, or in other words, the present value of all the future earnings that we will generate over our working lives.  This needs to be reflected in how we invest during the accumulation phase of investing.

As younger people have a long time to go before they will need the money, the advice they receive is often that excess earnings should be invested predominantly in equities.  A subtler approach takes into account the attributes of each person’s human capital, which ranges from bond-like to equity-like in nature.  Take for example a university professor and a fin-tech entrepreneur; the former has stable income, linked to inflation and job security; the latter has little income stability and, most likely, a high correlation to the equity markets. The professor’s human capital acts like a bond, the entrepreneur’s as an equity.

So, if they are both 40 years old and have the same level of financial capital, should they invest in the same way?  Intuitively, the answer is no.

Human capital should be treated like any other asset class; it has its own risk and return properties and its own correlation with other financial asset classes.

Ibbotson, Milevsky, Chen and Zhu (2007)[1]

Those with more bond-like human capital could well take on more risk and those with more equity-like human capital should, perhaps, take on less risk with their financial capital.  Ironically, it is also possible that those who choose steady, stable jobs may have lower tolerance to losses than the entrepreneur, and vice versa.  One can see the risk of this scenario.  Additionally, two partners may also have different levels of risk in their human capital. Imagine a professor married to an entrepreneur; together they form a balanced portfolio between bonds and equities and their investable portfolio of financial capital should reflect this.

Figure 1: How human capital attributes influence asset allocation

Source: Albion Strategic Consulting

Cash-flow modelling can help those in the accumulation phase of investing to understand the financial impact of changes to their human capital.  Owning sufficient life cover to protect the outstanding human capital should be an important part of the discussion.  It is difficult to see how a stockbroker or investment manager can structure a portfolio sensibly, particularly where the investor still has substantial human capital, without the insight into, and modelling of, the client’s total asset picture.  No financial portfolio is an island.

[1]      Ibbotson, Milevsky, Chen and Zhu (2007), Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance, Research Foundation of CFA Institute publication.

Other Notes and Risk Warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.