No fund manager would admit bias, let alone fear, longing and prejudice. But behavioural finance says that investors are subject to these emotions. Fiona Rintoul claims checklists are a useful weapon in the war against bias.
Why is the first thing you hear when you board a flight, “Welcome aboard the XYZ flight to Honolulu”? The answer is that it is on the captain’s checklist. It reminds him (or very rarely her) what their goal is. To fly to Honolulu.
And it reminds you, the passenger what your goal is in boarding the plane. To fly to Honolulu. If you wanted to fly to Kuala Lumpur, this is a good time to disembark the aircraft.
Pilots, surgeons and other professionals in jobs where it’s very important to get things right have mandatory checklists, because experience shows that they will mess things up if they don’t have them. Now behavioural finance experts are suggesting that investors – both private and professional – should have checklists too.
Behavioural finance studies the psychology of financial decision-making. According to a report from Vanguard entitled Behavioural finance: understanding how the mind can help or hinder investment success, behavioural finance has been growing over the past 20 years “specifically because of the observation that investors rarely behave according to the assumptions made in traditional finance theory”.
Traditional finance theory assumes that investors are rational and not swayed by their emotions. Behavioural finance recognises that they are swayed by their emotions.
“It’s really the study of imperfect decision-making by letting emotions play too great a role,” says Jon Ingram, portfolio manager at JP Morgan Asset Management (JPMAM). Ingram is one of the managers of the JPM Europe Dynamic fund, launched in 2004, run entirely according to behavioural finance principles. JPMAM started running money using behavioural finance principles in its UK business in the 1990s, and launched dedicated funds in the US in 2003 and in Asia in 2007. These funds are 100% behavioural finance and are run according to a “disciplined, rigorous process”.
“Every characteristic we look for has a behavioural underpinning as to why it should create outperformance,” says Ingram.
According to Ingram, the process differs from a quantitative process in that a quantitative process looks for characteristics that have worked historically. Behavioural finance seeks to understand why characteristics have worked.
By taking a behavioural finance approach, JPMAM also seeks to exploit the innate biases that a traditional fund management model delivers to the benefit of its clients. Knowledge is power.
“If you know what other people will do in a certain scenario, you can do one of two things,” says Steve Ruffley, chief market strategist at InterTrader and a professional trader, who tutors others by using the technique of live trading clinics. “Prove them wrong in the short term and make the market go the opposite way, or go with them. Nothing moves a market like people being wrong. This is the fund manager’s key weapon – making other people question themselves.”
JPMAM has a considerable commitment to investing along behavioural finance lines – Ingram reckons it has the largest team dedicated to behavioural finance currenty based in London – and its own process for doing so. However, many behavioural finance experts believe that all investment managers could benefit from taking behavioural finance principles into account in their investment process, and the most usual way to do this is through checklists.
“Academics are really collecting around this,” says Nick Blake, head of retail at Vanguard Investments UK. “There’s a whole science of checklists to save you from your own biases.”
First, of course, you have to accept that you have biases. This requires a certain humility, and, interestingly, Blake says that humility is the first quality that Vanguard looks for in the external managers it uses to run its actively managed funds.
However, humility is not the first quality that fund managers usually ascribe to themselves. Neither are fund managers likely to be lining up to talk about their biases, which might also be called fears, prejudices or longings. In fact, the whole way we speak about investment is designed to cover up the fact that investment decisions are so often driven by people’s emotions.
We are so used to hearing about “market sentiment”, “market exuberance” and “market jitters” that it is easy to forget that markets are things and cannot actually experience exuberance or jitters. Only people – investors – can feel, get carried away, become scared and so forth.
“No matter how you interpret it, the market is still run by people,” says Ruffley. “There are no super robots that control the markets. This means traders are susceptible to fear and greed just like everyone else.”
While we might be happy to accept that private investors make decisions based on emotions, we are generally less happy that professional fund mangers do this. No fund management company will write in a monthly report: “Our fund managers got the heebie-jeebies and sold all their investments in the auto sector”, or “Our fund managers got a bit over-excited about supermarkets”. Probably because no investor wants to read this.
Nonetheless, as JPMAM’s Ingram points out, practitioners are no different. They suffer the same biases as everyone else. Two of the most common biases that affect investors, be they private or professional, are overconfidence and loss aversion.
“Psychology has found that humans tend to have unwarranted confidence in their decision making,” says the Vanguard behavioural finance report. In an investment context, overconfidence can lead to too much trading with a negative effect on returns. It can also lead to self-attribution bias, whereby investors attribute positive outcomes to their ability and skill and negative outcomes to bad luck, thereby not learning from their mistakes.
Loss aversion prevents investors from dealing effectively with investments that lose money. Behavioural finance theory suggests that investors are more sensitive to loss than to risk and return, sometimes putting more than twice the weight on losses that they do on potential gains. This shows in the way investors obsess about in-price of stock.
“It’s easy emotionally to take profits,” says Ingram. “But if you bought a stock for 100 and it’s fallen to 95, it’s much harder to sell. That’s irrational because the price we paid for it is irrelevant to the future trajectory of a stock.”
In particular, investors like to see a stock come back to break even before selling. This, says Ingram, helps to explain why we haven’t seen even bigger outflows from emerging markets.
Behavioural finance is about accepting that those biases exist within you too. And it’s also about accepting that simply to know and acknowledge that is still not enough, and this is where checklists come in.
“Checklists are there for a reason,” says Ruffley. “Most people know the right answer but don’t choose to follow it. Fund managers are no different. To be ahead of the game, you have to understand the game – know the market participants better than you know yourself.” Vanguard has a four-point checklist of things investors should think about, and they are: goal (understand why you’re investing); balance (make sure you’ve got the right mix to achieve your goal); cost (do all of this at a low cost); and discipline. Vanguard’s Blake suggests the fourth point is best encapsulated by the phrase: in the event of a crisis, don’t just do something, stand there.
“Often the best thing to do is to nothing,” says Blake, “but because human beings are emotional they feel the need to respond particularly in times of high stress.” This checklist of goals is aimed at private investors and their advisers, but, says Blake, it could apply just as well to professional investors. The main things is to have some kind of brake that stops you acting on your emotions.
In an investment advice context, behavioural finance theory and the idea of checklists fit with recent regulatory developments. In world of fee-based advice, advisers become financial coaches. A lot of the heavy lifting should be done at the start, suggests Blake, and then portfolios should be pretty much left alone apart from scheduled rebalancing.
“Advisers are now the fiduciary managers of their clients,” says Blake. “In the words of Vanguard’s founder, Jack Bogle: ‘the adviser’s job is to stop their clients making dumb mistakes’.”
For fund managers, you could say that behavioural finance theory is about stopping themselves making dumb mistakes. It’s a view of investment that is about checking and being careful. It’s not especially exciting. But if you want excitement, maybe you should go to a casino.
Take it from a man who trains others to trade in real time with his own money and has allegedly only made one loss in 25 live trading sessions over the past two years: “Emotions are the true enemy of any trader,” says Ruffley.
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