Emotions are great. Just not when it comes to Investing.
The following article by Scalable Capital looks into the biases surrounding our behaviour when investing. Benjamin Graham once said that “the investor’s chief problem – and even his worst enemy – is likely to be himself”. What Graham meant by that is that we all have emotions and biases that affect our decision-making. Failing to understand our own behavioural biases and how to overcome them in investing can negatively affect our portfolio performance.
Typically, being an emotional investor manifests itself in two ways: by buying stocks at the highest valuations as excitement builds up, and by selling near the lows out of panic. This is how stock market bubbles happen, over and over again: be it the Internet bubble of the late 1990s or the housing bubble in the past decade, these events clearly have an emotional component.
History is Littered With Burst Bubbles
S&P 500 since 1996
Here are some of the most common behavioural biases when it comes to investing:
Your parents may have asked you as a kid: ‘If all your friends jumped off a cliff, would you?’. This question is especially relevant when it comes to investing. Fear and greed are powerful motivators, and no one wants to miss out on market movements. This is why many investors buy and sell the same stocks, at the same time, and track each other’s investment strategies. But just because everybody does something, that is not a good enough reason to imitate them. In short, many investors are prone to follow the lead of others, even when the herd is heading off a cliff.
This bias occurs when investors have a preference for familiar investments despite the seemingly obvious gains from diversification. Investors display a preference for local assets with which they are more familiar. An implication of familiarity bias is that investors hold suboptimal portfolios. To overcome this bias, investors need to expand their portfolio allocation decisions to gain wider diversification.
When investors sell winning assets too soon and hold on to losing assets for too long, we call this anomaly the disposition effect. This is also known as the “sunk-cost fallacy”. It is based on the idea of keeping a poor investment in the hope it may recover. For example, if someone buys a stock at £30. This then drops to £22 before rising to £28, most people do not want to sell until the stock gets to above £30.
Confidence can easily turn into overconfidence after a few easy wins. We tend to overestimate our intelligence and capabilities relative to others. This mindset often leads to suboptimal portfolios due to a lack of thorough data collection or rash interpretations that cannot always be objectively justified.
Outsourcing to an algorithm is the future of investing.
The idea of outsourcing self-control is an established concept and a key point of study within behavioural economics. When it comes to investing, if human decision-making is inherently flawed, an optimal mix of technology and automation can help. Algorithms can automate your investments and replace human quirks with data-driven decision making, reducing costs and streamlining the investment process at the same time.
Automated investment managers or so called “robo advisors” can construct and maintain a systematic investment process, to provide more protection from ‘bad behaviour’ than ever before. By automating your investment portfolio, you’re also able to reduce fees, increase efficiencies and streamline the process through a simple online interface.
It is hard to imagine markets achieving perfect efficiency or humans achieving perfect rationality anytime soon. This is why at Scalable Capital we use technology to help mitigate the ‘bad behaviour’ of investors. We take emotions out of investing as our investment method is designed to avoid irrational decisions. With us, changes in our clients’ portfolio allocation are based on a clearly defined algorithm and not individual judgements of the market.
Investors do not need to make any decisions; we do everything for them. Our ability to quantify risk, gives clients a better understanding of their investment. This aims to provide them with improved risk-adjusted returns. Their money is invested across all major asset classes and 14 different ETFs. As such, providing a broad exposure to 8,000 individual securities spread across 90 countries. Aiming to provide the benefits of global diversification.
We also provide investors with an unprecedented level of transparency. This is done through a complete overview of their portfolio allocation and all adjustments we have made. The process of visually seeing somebody acting on your behalf to help you build your wealth provides peace of mind. Often this is not possible with traditional managers. This takes out fear of the unknown, and allows investors to hold steady even during downturns. All without them having to sit on the sidelines because they traded out in a panic.
Please register with Scalable for more information on their investment opportunities.
UK CEO & Co-Founder at Scalable