Posts in behavioural finance
Don't base your investment decisions on the economy

It seems logical to believe that the performance of a country's stock market is linked to the state of its economy. After all, if GDP growth is strong, company profits are good, and that should help share prices.

Economic prospects are even often used to identify which stock markets are likely to perform in future. If a country is experiencing positive GDP growth, then investors are encouraged to see it as a good place to put their money.

What the evidence reveals

Yet several studies have shown that this link is actually weak. A comprehensive analysis of 21 countries over more than 100 years by the authors of the book Triumph of the Optimists found mixed results between GDP growth and stock market performance.

An MSCI analysis in 2010 found similar results. Most notably, for the 60 year period from 1958 to 2008, Spain and Belgium enjoyed real growth in their economies of between 3% and 4% per year, yet the real returns from their stock markets over this same time were negative.

One of the clearest examples of the potential breakdown between a country's economic performance and that of its stock market has been Japan. Since 1989 the country has grown its economy at over 1.5% per year, yet the Nikkei 225 Index is still well below its December 1989 peak. That is a period of more than 30 years in which Japan's GDP growth has not been reflected in broad market returns.

A closer look

This doesn't only occur over the long term either. It can also be play out from year to year.

The tables below, which consider the last 90 years of GDP growth in the US, make this clear. On the left are the 15 calendar years during this period in which US growth was weakest, and on the right are the 15 years in which it was strongest.

Economics.png

What stands out is that in more than half of the worst years, returns from the stock market were still positive. In six of them, the S&P 500 was up more than 20%, even though GDP growth was zero, or negative.

Not quite as striking, but nevertheless noteworthy, is that even in some of the best years for the US economy, the stock market fell. Incredibly, in 1941, when GDP growth was 17.7%, the S&P 500 declined 12.8%.

Understanding the gap

It is clear from these studies that the state of a country's economy should not be seen as a guide for how its stock market is likely to perform. As MSCI notes, there are three main reasons for this.

“First, in today’s integrated world we need to look at global rather than local markets. Second, a significant part of economic growth comes from new enterprises and not the high growth of existing ones; this leads to a dilution of GDP growth before it reaches shareholders. Lastly, expected economic growth may be built into the prices and thus reduce future realized returns.”

Investors should therefore be cautious about basing their decisions on economic data. This has even been apparent in the UK over the past five years.

The story in London

Since 2014, the local economy has mostly staggered along at growth rates below 2%. Yet, the FTSE All Share Index has delivered an annualised return of 9.4%, which in today's low inflation environment is a real return of close to 8%.

If an investor had stayed out of the market due to fears around Brexit and the country's general lack of economic momentum, they would have missed out on this period of growth.

Similarly, those who argue that the US stock market is going to continue to show good returns almost always base their argument at least in part on the fact that the US economy is still strong. As history is shown in the case of Japan, however, a growing economy does not necessarily equate to good returns for investors on the stock market, particularly if share prices are already high.

Trying to guess which markets may or may not deliver the best returns in future based on the economic prospects of the country in which they are based is therefore not a way to investing success. Investors are far better off building a strategy diversified across markets that they can stick to no matter the economic environment, and reap the rewards over the long term.

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Why overconfidence in investing can be dangerous

Generally speaking, it’s good to have a positive outlook on life. But too much optimism, or overconfidence, can be a problem, particularly when it comes to investing.

In this video, Lisa Bortolotti, Professor of Philosophy at the University of Birmingham, explains why investors need to be realistic.

You will find plenty of helpful videos like this one in our Video Gallery. Why not have a browse?

Video transcript:

Generally speaking, it’s a good thing to have a positive outlook on life, and to be reasonably optimistic about the future. It’s better for our health and mental wellbeing for a start. But there are potential pitfalls too. Lisa Bortolotti is Professor of Philosophy at the University of Birmingham and an authority on the dangers of overoptimism and overconfidence.

“I think, where you see the negative effect is where you have context, where things are so complicated that being optimistic about your competence or your performance leads you to making mistakes and taking too many risks. So, finance is an obvious case. Finance is very complicated. You need to take into account the relative value of different options and the idea that you will make the best decision because you’ve made a very good decision in the past where you tend to think your previous luck as skill makes you too confident about the decision you make and less likely to listen, maybe, to other people and take into account different factors.”

A tendency towards optimistic bias or unrealistic optimism is part of the human psyche. It’s the way we’ve evolved. Behavioural experts have identified different dimensions to it. One of these they refer as the Illusion of Control.

As Bortolotti explains, “The Illusion of Control is when something is happening and we witness the thing happening and we tend to think that we are actually interfering with what is happening and determining the outcome. I think, in the financial world it’s possible that we may think that we will be able to know whether a certain company will be successful or whether certain rates will go up or down. And this capacity, that we think we have to predict how things will go, will make us make decisions that are more bold and do not take into account other factors that we should factor in.”

Another aspect of optimism bias is the so-called Illusion of superiority. In other words, thinking we’re better than we actually are.

“The superiority bias, which is also called the 'Better Than Average Effect’, is the idea that we tend to think of ourselves as better than average - in a number of domains. So, we may think that we are more attractive, smarter, more generous as well. Now, The better than average effect has been observed across the board and it normally works in combination with the optimism bias to make us make predictions about the future that are too positive, too rosy, because if I think that I have a lot of skills and a lot capacities and I think that things that are negative will not happen to me, then I will think that I can control what happens in the future, and I can determine a future that is happy for me.”

Again, it’s good to be optimistic and confident to a point. In fact, you need to have a positive view of the future to invest in human enterprise in the first place. But be realistic, and don’t overestimate your ability to outperform other investors.

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A history lesson that is still as relevant as ever

This year marks the 300th anniversary of one of the world's most famous financial catastrophes: the South Sea Bubble. It is a story with complex origins, but the pattern of events in 1720 has unfortunately been repeated in similar ways many times since.

It is not necessary to know all the details to appreciate what happened in London three centuries ago. However, it is worthwhile to look at how ordinary people were drawn into mistakes that left many of them ruined.

Money from nothing

At the start of 1720, stock in the South Sea Company was changing hands at £128 per share. The company was only moderately profitable, and the trade it ran between Britain and South America was small.

Its directors, however, were full of stories about how the riches of that continent were ready to be brought to Europe. Since the South Sea Company did have exclusive rights to provide the Spanish colonies with slaves, and to send one trading ship to the continent per year, these stories did have a kernel of credibility. They were, however, easily inflated.

The South Sea Company's main business had always, in fact, been supporting the British national debt. Since 1711 it had provided millions of pounds in funding to the government by selling its own shares.

It had become so important to the state that King George I was appointed as the company's governor in 1718. In 1719 it agreed to restructure more than half of the national debt in a way that would reduce the government's interest payments.

Growing interest

This gave the company room to issue even more shares on the public market. To make them more attractive, the directors not only pushed the idea that its South American trade was set to take off, but also came up with a scheme that allowed investors to buy these shares in instalments rather than having to pay the full price upfront.

This made them available to many more people, a lot of whom had no real idea what they were buying. They were however seduced by the rising share price and the tales of South American wealth.

By February, shares had climbed to £175, and in March they reached £330. May took the stock to £550.

Not wanting to miss out on this opportunity, more people bought more shares, and the price went up further. In August, the stock was up almost ten times in just eight months, at over £1 000, and the euphoria was at its peak.

However, just as suddenly as it had began, the bottom fell out of the market. At the price being asked, there were simply no more buyers.

Within months, demand for the shares collapsed. By December, the company's shares had slumped back to £124 and many people had lost huge amounts of money.

Repeating history

The lesson most often associated with this series of events is that investors should be wary of anything that becomes a 'sure thing' in popular opinion. Almost everybody was certain that shares in the South Sea Company were only going to keep going up, and the rapidly rising price appeared to confirm their view.

The danger is that when this kind of thinking takes hold, it does become a self-fulfilling prophecy for a while. The price of South Sea Company shares kept going up because people kept buying them. However, at some point the limit of buyers will be reached, and from there the crash back down can be brutal.

The more subtle lesson, however, is that most of the ordinary investors who were buying the company's stock did not know or understand what they were buying. Not only was trade in shares still novel to them, but they did they not appreciate that the South Sea Company's shipping operations were not its main focus. They also had no idea of the complexities involved in its relationship with the British government.

A recent Bloomberg article noted how more and more ordinary investors today are buying complex financial products that have become available to them due to technology. These include forex, leveraged exchange-traded products and cryptocurrencies.

These products are not necessarily going to create bubbles, but they do seem 'sexy' because they can make rapid gains. This, however, is exactly what makes them dangerous. Anything that can go up quickly can can down just as quickly, and these sudden price movements can be devastating.

The South Sea Bubble should stand as a reminder that successful investing is not about chasing the most exciting opportunities. It is actually the opposite: be boring. Diversify, keep your costs down, and let the market do its work over time.

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Regret is the greatest enemy of good decision-making

Regret has been cited by Nobel laureate Daniel Kahneman as probably the greatest enemy of good decision-making in personal finance. It is often the driving force behind panicky attempts to time the market, buying at the top or selling at the bottom. It can prompt us to place a far greater weight on the possibility of suffering a loss than the prospect of a win.

Landmark research by Kahneman and his partner Amos Tversky in the 1970s found that when confronted with several alternatives, people tend to avoid losses and choose the sure wins because the pain of losing is greater than the joy of an equivalent gain.

We prefer the safe option

In one famous experiment, students were given the choice of winning $1000 with certainty or having a 50% chance of getting $2500. Most people will choose the safe option of money in hand. Conversely, when confronted with the choices of a certain loss of $1000 versus a 50/50 chance of no loss or a $2500 loss, people tend to choose the gamble.

In other words, we tend to switch from opting for risk aversion when it comes to possible gains to risk-seeking behaviour when it comes to avoiding losses.

Asymmetric choices

What’s more, regret, at least in the short term, tends to be stronger when it relates to acts of commission than of omission — in the former case, the things we did do and in the latter case the things we didn’t do.

As an example of omission and commission, imagine Jane has held a particular stock for some time. She thinks about selling it but does not follow through. The stock subsequently slumps in price. In contrast, John sells his stock, only to see it rally.

In the first case, the example of omission, or inaction, leaves Jane feeling less regretful than in the second case, John’s example of commission, or action.

Put another way, there is an asymmetry to our choices when confronted with uncertainty than is assumed by traditional rational choice theory in which human beings are cast as automatons carefully weighing the costs and benefits of their decisions.

We’re less logical than we think

The fact is we are not the logical decision-makers we assume ourselves to be. Instead, we are highly susceptible to behavioural biases that cause us to place a greater weight on the possibility of losses than on the prospect of gains – even when the statistical odds of the competing outcomes are identical.

We would rather secure a guaranteed lesser win than opt for the choice of getting more or possibly ending up empty-handed. And given a choice of two bad outcomes, we’re more likely to roll the dice to avoid the worse one.

This is why many people remain doggedly loyal to a particular bank, for instance, even when they are being ripped off by inferior service and excessive fees. It also explains why many people won’t cut their losses and dump a losing stock (because they’ll regret it if it bounces back afterwards).

Regret risk is frequently seen in bull and bear markets. In the case of the former, with stock averages hitting repeated record highs, there’s a natural tendency to want to hold back for ‘more certainty’. In the case of the latter, we want to wait to see the bottom before we wade in.

We’re not good at probabilities

In all cases, we imagine we are carefully calculating probabilities when, in reality, we are slave to our emotional instincts and resorting to mental short-cuts to justify our decisions ex-post.

Kahneman’s approach to regret risk in wealth management is to seek a balance between minimising regret and maximising wealth. That means planning for the possibility of regret and understanding clearly the range of possible outcomes beforehand.

Why an adviser helps

Of course, there is no one right answer here and that’s because everyone is different. It’s also why it is so important to have a financial adviser who can map out the range of eventualities and test clients’ potential reactions to each one.

Everyone has investment regrets. They’re part of being human. The important thing is to learn to get over them, so they don’t derail your decision-making process.

Picture: Sarah Kilian via Unsplash

How women view money and investing differently

In most relationships it tends to be the male partner who makes the financial decisions.

Yet in many respects women are better at dealing with issues of personal finance than men. There’s certainly plenty of evidence to suggest that women, on average, are more successful at investing.

Why, then, do so many women shy away from finance and investing?

In this video, Dr Moira Somers, a financial psychologist at the University of Manitoba, gives some interesting pointers.


You will find plenty of helpful videos like this one in our Video Gallery. Why not have a browse?

Video transcript:

Robin Powell: Research into couples and their personal finances consistently shows that it still tends to be men who make the investment decisions.

But women tend to have a different attitude towards investing, and when they are involved, they often make better choices.   

Dr Moira Somers is a financial psychologist at the University of Manitoba.

Moira Somers: My understanding of the current research is that women are much more conservative investors. They often wait far too long to get into investing. When they do start investing though, they tend to have better returns than men, because they are more prudent. They don’t seek the extreme reward end of the spectrum. They are content with more modest returns and they tend to achieve them. 

RP: Surveys repeatedly show that money is one of the main causes of stress. Women are especially prone to worrying about it.

MS: Another gender difference is that women tend to stress more about money. They will acknowledge that they lose sleep more often than men do. And, sometimes, that’s because they do not have sufficient knowledge of their own family finances. They’re not the ones in control. You know how sometimes it’s harder to be a passenger in the car than a driver? You’re glad somebody else is driving but you still have absolutely no control about what’s happening. So, it’s a different kind of stress. 

RP: So, a lack of knowledge about investing is one reason why women aren’t more involved in investment decisions. But Dr Somers says there’s another key factor.

MS: When we survey them, when we work with them to say: “How come this isn’t so easily transferable for you? You have brilliant skills in household management, why is this not translating into the broader financial picture?” And some of it, frankly, has to do with mistakes that advisers make. There are some real big turn off’s, real big mistakes that just leave women feeling stupid and embarrassed and uncomfortable and so they vote with their feet.  

RP: Having the wise counsel of a good financial adviser is extremely valuable. There are signs that the advice profession is starting to serve women better than it has in the past, but there’s plenty of room for improvement.

So, don’t be put off by negative experiences. Find an adviser you trust and feel comfortable with. 

You can find out more about Dr Somers’ work via her website, moneymindandmeaning.com.

Check out more of the latest news from IFAMAX:

Pay less attention to weather forecasts

A little encouragement goes a long way

Weekly round-up: Week 48, 2019

Picture: Alice Donavan via Unsplash

Why a long-term focus is key


It’s not mentioned often enough in the financial media that many of the keys to success as a long-term investor derive from qualities that are distinctly out of tune with the times. These include patience, discipline and crucially, delayed gratification — a readiness to prioritise distant rewards over instant ones.

In fact, the times we’re living in are almost antithetical to long-term investment. We are overwhelmed by choice. We are told we can have everything we want right now. And, if we can’t afford it, we can put it all on the plastic and worry about paying for it later.

 

All gain-no pain has a ready market 

The fact is there’s a ready market for the notion of all gain-no pain. Witness the dieting magazines that promise their subscribers perfect bodies with little expense or effort other than the cover price and sticking reminder listicles on the refrigerator door.

It works similarly in the investment world. Much of the financial services industry, and the media that serves it, wants people to believe in the idea that investment returns come down to “hot tips” and easy shortcuts. The giveaway pitch is “high returns with low risk”.

A dissenting view about the instant gratification, you-can-have-it-all-right-now economy has been memorably expressed by Charlie Munger, the business partner of legendary investor Warren Buffett and a man known for turning conventional wisdom on its head.

 

We can’t stand to wait

“Waiting helps you as an investor and a lot of people just can’t stand to wait,” Munger once said. “If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.” 

Perhaps it’s due to the nature of modern consumer capitalism, which runs on encouraging people to pursue an endless and unquenchable cycle of externally generated desires. In other words, the notion of delayed gratification is out of tune with the times we live in.

But the ability to forgo today’s desires for the prospect of longer-term fulfilment is one of the most elemental requirements for success as an investor. Buffeted by media noise and the lure of short-term returns, we have to be able to resist the temptation to tinker.

Again, as Munger put it: “People are trying to be smart. All I am trying to do is not to be idiotic, but it’s harder than most people think.” 

 

One in five don’t plan for the long term at all

Just how hard it is was highlighted in a recent report by the UK online wealth management firm MoneyFarm, which looked at why as a society we seem to find it so difficult to invest in our future wellbeing and are so easily distracted by short-term temptations.

The research found that 21% of Britons don’t plan for their long-term future at all. And a further quarter (25%) think less than six months ahead. Five years was the furthest that most people (29%) currently plan for.

The causes of this short-termism are many, the report says, including a surfeit of choices and a subconscious view that by opting for one we limit our own freedom. Another factor is that thinking about our long-term future creates anxiety, which we treat with instant consumption.

How do we deal with it? The report recommends a number of strategies, such as imagining the most positive outcome from a change in our financial behaviour and consciously thinking about the biggest obstacles to our getting there.

 

Social support is important

Another underrated technique is galvanising social support around our goals from friends, family and professional advisers. The need, as Munger says, to wait patiently, to not do stupid things and to stay focused on a long-term goal is hard to do alone.

But the first step is setting the goal and building a plan to achieve it.

You can download the full MoneyFarm report here.

Check out more of the latest news from IFAMAX:

Pay less attention to weather forecasts

How women view money and investing differently

A little encouragement goes a long way