While we cannot escape the traits that make us human, an understanding of behavioural economics can make us better investors. Pau Morilla-Giner, Chief Investment Officer at London & Capital, explains how he builds behavioural factors into asset allocation and investment selection for client portfolios, and why it is necessary for consistent, risk-managed returns.
Why is recognising behavioural traits important in investment?
The first step to solving a problem is recognising that there is a problem. If we recognise that cognitive biases are happening, we can see how that is translating into our decision-making process.
In all of our investment decisions, we try to step back and solve the problem before us. Before we start any investment journey, we develop a plan. If we understand some of the key behavioural traits – over-confidence, for example – we can see where it is happening. It gives us a framework to assess whether our views are correct.
What have been some real-life examples of how behavioural biases play out in markets?
Any sort of bubble is a behavioural-driven phenomenon. It starts with people investing because of fundamental reasons, and then moves to people believing that because an asset has gone up before, it will continue to do so. This is availability bias – taking the most recent data or events and extrapolating it forward: it wins today; therefore it must win tomorrow. Investors will also start to follow the herd, another key behavioural trait. Doing what everyone else is doing has worked well for us over the years and is hard-wired into our brains.
This creates a situation where people are buying for the sake of buying rather than because of an asset’s value. That is what every bubble is about. People go from investing because it makes sense, to investing because everyone else is doing it. This has been a common theme from tulips to dotcoms.
How does your firm incorporate this into your process?
We guard against it in two ways. The first is pre-emptive. Before we launch a new portfolio, or a new theme, we develop a trading plan – what we’ll buy and what drives our positioning. We will set all the milestones before we start to build our position. Once the journey begins, fear, greed and a myriad of cognitive biases can cloud judgment, so it is important to think about how we are going to do something and set parameters before executing.
The second check comes in our investment committee meetings. We will go through a list of our main biases one by one. We will look at, say, over-confidence and ask whether we could be wrong in our assumptions; we ask whether we are anchoring our expectations - are our views affected by the earnings of the previous year, or are they fresh and new?
How do you balance conviction and over-confidence?
We can build conviction when we know we have done the best analysis with the information available. Over-confidence, in contrast, is simply believing that you won’t be wrong. Good analysis always allows for error, even when there is conviction. We may believe the dollar will go up, but we need to build in an awareness of what would happen if that didn’t happen. We need to be aware there is an alternative argument. Over-confidence leaves no possibility of that alternative argument.
Which of these behavioural characteristics do you believe are the most important?
Most can have a significant impact on portfolios. Loss aversion, for example, means that even when things are going wrong, investors don’t tend to cut losses, and that can hurt returns. Availability bias is the belief that what is most recent will keep happening, and can be a constant bombardment for investors. Related to that is the confirmation bias. For example, an investor may believe Trump is good for growth and then go and seek out research that confirms that view, rather than finding research that helps develop alternative and more challenging views.
The herd mentality is hard to resist. There is comfort in doing the same thing as everyone else and it is tough to stick your neck out. If you make a mistake, it is more acceptable if everyone else has made the same mistake. We try to use analysis to develop our view, rather than having a view first of all, and then finding the right analysis to support it.
Is it possible to avoid behavioural mistakes?
No. They are a result of us being human and thousands of years of evolution. Investors can’t help it; they can only be aware of it and try to guard against it.
Why is an understanding of behavioural economics important to good investment performance?
It forces us to avoid mistakes, to be more consistent. If we recognise the problems associated with cognitive distortions, it helps us to resolve the problems far quicker than if we didn’t know what to look for. This is part of why we’re different. We spend time trying to recognise how to tackle these problems.