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Bad investment behaviour will cost you money

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Thursday May 16, 2013 at 9:00am
In 2002 the Nobel Prize for Economics was awarded to Daniel Kahneman, a Princeton University psychology professor. He had never even taken a course in Economics. However, Kahneman was recognised “for having integrated insights from psychological research into economic science, especially concerning human judgment and decision making under uncertainty.”

We have long advised clients that investment success is as much to do with their own investment behaviour as it is to the performance of the capital markets. The reasons for this come directly from Kahneman and other researchers. Their evidence is that people persistently make poor decisions, especially in situations characterised by complexity and uncertainty. Behavioural biases such as overconfidence, hindsight bias and over reaction to infrequent events lead to significant errors of judgement. In other words, rather than worry about the remote possibility of coming to a sticky end in a plane crash simply ensure you use a seat belt in the car as this is a much more common and dangerous way to travel.

Overconfidence in investments leads to poor decisions

In the investment world overconfidence leads to people and managers trading on poor information which is little more than financial noise, they trade too often and end up with an excessive concentration of investments rather than proper diversification. According to the academics, people are overly impressed by managers who “sell” what they have been doing for the past few years without realising that they would get similar returns if there was no skill in picking stocks or running funds.

Kahneman pointed out that a glaring example of investor irrationality is their confidence that markets can be beaten by a clever few. Any stock market is comprised of millions of individuals which makes it extremely unlikely that any one person (without inside information) can beat the market. The question is - why people believe they can do the impossible and why do investors believe them?

Investment industry encourages an irrational response

You can’t blame investors for this; to a large part the investment industry reinforces irrationality by promoting a belief in disequilibrium. They would have us believe that the price of specific equities or even entire asset classes are either overvalued or undervalued. And consequently they tempt investors to enhance their returns by switching from one equity or asset class to another. Interestingly the fund charges a fee for the advice and the investor takes the risk on whether they really can predict the future or not.

It is a reality that markets are volatile and short term anomalies do occur for which some alternative managers such as hedge funds can be spectacularly successful in the short term. Even in these anomalous situations the investor is at a disadvantage. Such talents in the short term are in high demand which means that like any scarce resource; recently successful fund managers command a high price. Hence a successful hedge or equity fund will raise fees, thus diluting the payoff from their research. In the end the providers of the scarce resource, the fund managers and not investors will reap the bulk of the benefit.

Investment is all about risk and reward

So, there is no free lunch, the market provides a return significantly higher than cash over the long term, in return for investors taking more risk. All of this risk other than the all-important risk of the market can be diversified away with a properly diversified portfolio.

If you want to know more about our investment philosophy and globally diversified, low cost investment portfolios I’d be happy to tell you more.

Andy Parker
Chartered Accountant and Chartered Financial Planner

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Parker Chartered Accountants and Financial Advisors is the trading name for Parker Business Development Ltd (Registered No. 4116664), Parker Tax and Trust Ltd (Registered No. 06950353) and Parker Financial Planning LLP (Registered No. OC347027). Parker Financial Planning LLP is authorised and regulated by the Financial Conduct Authority. All companies are registered in England and Wales – registered office contact details here