We are currently investing in an extremely noisy political and economic environment. While markets have remained remarkably subdued during recent times, it is inevitable that greater volatility will emerge. The question is: how should we respond?
As investors, our natural impulse when faced with arresting news or growing uncertainty is to react. Our instincts tell us to take action to protect portfolios or to profit from a particular outcome. This adrenaline fuelled ‘fight or flight’ response is deeply ingrained within us and exists for good evolutionary reasons as early humans who did not have these instincts were less likely to have decedents.
However, this impulse towards action causes a real challenge for investors.
There is an abundance of great research on this topic; however one of the most relevant was a study by Barber & Odean which shows a clear link between portfolio turnover and the results generated by individual investors.
Those portfolios in the highest quintile of turnover delivered returns more than a third lower than those in the lowest quintile of turnover. To say this simply, the impulse towards action is not beneficial to returns.
The Impulse to Action
Alongside the evolutionary impulse and incentives, action is also being encouraged by an array of behavioral biases that revolve around overconfidence, the rejection of opposing views and a preference to recall the recent past.
Most vividly, the ‘recency bias’ makes our recent experience easier to imagine than those experiences that are more distant. This leads us to believe that current trends will continue indefinitely. In contrast, the ‘law of small numbers’ is another behavioral trap that creates an expectation of mean-reversion in small sample sizes, thus encouraging investors to risk too much capital on positions designed to capture small market deviations.
In view of this, it is hardly surprising that most portfolios managers and advisers are far too active in their investment operations. We typically see this via increased costs and poor performance.
Overcoming the Impulse towards Action?
To get practical, there are several strategies to help overcome this impulse to action. The key is to prepare rather than react, as it is likely too late to address the impulse for action when it arises. For the portfolio manager or adviser to overcome the urge to make unnecessary changes to the portfolio, it is important to initiate the strategies beforehand. A good example of how to do this is provided by the story of Odysseus facing the Island of the Sirens as he returned from the Trojan War.
Our hero knew the encounter with Sirens was both inevitable and dangerous and so he prepared himself beforehand.
In this sense, the best preparation was education. Most clients are unaware of both their behavioral biases and the impact that those biases have on a portfolio. A basic education in behavioral science is therefore the first step, as investors who are aware of their biases are less likely to fall foul of them and more likely to be understanding of the adviser’s attempts to overcome them.
Second, one should ensure they have good navigation aids. Our biases create structure to our decision-making that results in predictable mistakes, much like a poorly drawn chart creates repeated navigation errors. In order to overcome this, we need to ensure that we use navigation tools that are fit for the job and enable us to overcome the inevitable obstacles in our path. One of the more popular ways is to create a core set of investment principles that are drawn from the observations of how great investors overcome their biases.
The third is to change the narrative of market movements. Much of the impulse to action comes from the type of investment data we consume and how we consume it. For example, many investors are drawn to recent past performance with an upward moving graph and green numbers. In contrast, red numbers and falling charts create a negative connotation. This naturally exposes us to loss aversion.
Avoid overhyped financial news and broker research designed to prompt action. Instead, one should be incentivised to focus on long-term prospective returns using a fundamental valuation framework.
By doing so, we change the itch to ‘buy high and sell low’ and turn it into a compulsion to ‘buy low and sell high’. Said another way, a rise in prices is viewed as a fall in prospective returns. While this helps address the recency bias, it also reduces exposure to the law of small numbers as most daily movements in asset prices appear to be vanishingly small in the context of a decade long return expectation.