Investment Insight | All biases covered
If the COVID-19 market sell-off in early 2020, as countries locked down, spooked individual investors worldwide, then the recovery has made them uneasy. Today, share markets are at or above their pre-COVID-19 highs. Humanistic biases are leading some individuals to again react in a way that may not be in their long-term interests. A better approach is readily available.
Not so Modern Portfolio Theory
In 1952, Harry Markowitz published a breakthrough essay on Modern Portfolio Theory which showed the value of diversification and portfolio construction. This theory now underpins the investment approaches of most investment managers and financial advisers. It assumes investors process information in the same ‘numerically rational’ way and stay the course, remaining invested over the longer-term.
But people are people and we react differently. During the COVID-19 market sell-off, many individual investors felt overwhelmed by fear and the potential magnitude of the decline. Some sold their investments and moved to cash, or switched their KiwiSaver from growth to conservative, crystalizing losses. Others stopped regular savings programmes and missed out on investing at reduced prices.
Moments like these, when sudden events catalyse a reaction, highlight a common obstacle to achieving investment success. The portfolio changes these individuals made meant they will not have fully participated in the subsequent recovery, often significantly impacting their savings. It may also leave them with a wariness of share markets as a means to building wealth, even if the recovery is faster than predicted (see graph). And by not staying the course, these investors discredit Modern Portfolio Theory.
Behavioural Finance
Reactions such as these have led academics to reconsider Modern Portfolio Theory and develop a field known as Behavioural Finance which looks at investors’ decision-making processes. The field helps understand why individuals make financial choices and, in turn, how those choices affect markets. It assumes individuals are not rational, but rather are influenced by humanistic biases. Although many biases have been identified, here are five that investors should be aware of.
1. Recency bias: Recency bias occurs where an individual's memory of a recent event leads them to believe the event is much more likely to reoccur. The Global Financial Crisis of 2008 and 2009 led many to exit the share market with a view that more economic hardship would follow. In reality, the economy recovered, and markets advanced over the ensuing decade.
2. Loss aversion: Individuals are afraid of losses. Research shows that losses of a given magnitude create more pain than the pleasure derived from gains of the same magnitude – by a factor of around two. Mental shortcuts driven by loss aversion regularly undermine the ability of individuals to stay focused on longer-term goals.
3. Hindsight bias and overconfidence: Hindsight bias is where individuals believe they predicted an event when in fact they had only considered it a possibility. It often reinforces over-confidence which leads to an unjustified belief in an individual's ability to predict the future. Overconfidence frequently expresses itself in individuals believing they can correctly time buying or selling investments at the bottom or top of the market. Yet, after they transact, the price often continues in the same direction.
4. Confirmation bias: Confirmation bias is where individuals have a tendency to accept information that confirms an already-held belief. If new information surfaces that confirms their view, it is quickly taken as confirmation, even if the information is flawed, whereas if contradictory information surfaces, they discount it.
5. Anchoring bias: Individuals can be heavily influenced by a reference point or ‘anchor'. Investors might lock onto a particular price of an investment (a ‘high water mark'), or the dollar figure for a portfolio, and disregard other relevant information. For example, it might lead to irrational decisions because they measure outcomes against a number that does not reflect underlying fundamentals. Or they might hold onto an investment longer than they should, waiting for a particular price point.
Better approaches for the longer-term
Fortunately, we are not condemned by our programming. To be successful longer-term investors, individuals need to be aware these biases are at play and take steps to work around them.
One approach is to obtain professional advice. Financial advisers know not to let biases influence their advice to clients. They focus on helping their clients maximise the chance of financial success over time by working with them to define their goals and understand their risk profile, then designing a plan and a portfolio to achieve those goals. Importantly, once in place, the portfolio is regularly rebalanced to the optimal asset allocation, a process which automatically takes into account swings in market prices.
Another approach is to choose a life-cycle investment option, which progressively reallocates investment allocations each year depending on the investor's age. NZ Funds offers an optimised lifecycle investment option as part of some of its investment products.
The NZ Funds investment team also considers Behavioural Finance as part of its intelligent investment approach. It actively seeks to mitigate the downside in a falling market and capture the upside in a rising market. One tool it uses is the Universa Black Swan Protocol which acts like an insurance policy to offset violent market sell-offs.
These approaches can give investors the confidence to stay the course, whatever the market environment, and achieve longer-term financial success.
Not so Modern Portfolio Theory
In 1952, Harry Markowitz published a breakthrough essay on Modern Portfolio Theory which showed the value of diversification and portfolio construction. This theory now underpins the investment approaches of most investment managers and financial advisers. It assumes investors process information in the same ‘numerically rational’ way and stay the course, remaining invested over the longer-term.
But people are people and we react differently. During the COVID-19 market sell-off, many individual investors felt overwhelmed by fear and the potential magnitude of the decline. Some sold their investments and moved to cash, or switched their KiwiSaver from growth to conservative, crystalizing losses. Others stopped regular savings programmes and missed out on investing at reduced prices.
Moments like these, when sudden events catalyse a reaction, highlight a common obstacle to achieving investment success. The portfolio changes these individuals made meant they will not have fully participated in the subsequent recovery, often significantly impacting their savings. It may also leave them with a wariness of share markets as a means to building wealth, even if the recovery is faster than predicted (see graph). And by not staying the course, these investors discredit Modern Portfolio Theory.
Behavioural Finance
Reactions such as these have led academics to reconsider Modern Portfolio Theory and develop a field known as Behavioural Finance which looks at investors’ decision-making processes. The field helps understand why individuals make financial choices and, in turn, how those choices affect markets. It assumes individuals are not rational, but rather are influenced by humanistic biases. Although many biases have been identified, here are five that investors should be aware of.
1. Recency bias: Recency bias occurs where an individual's memory of a recent event leads them to believe the event is much more likely to reoccur. The Global Financial Crisis of 2008 and 2009 led many to exit the share market with a view that more economic hardship would follow. In reality, the economy recovered, and markets advanced over the ensuing decade.
2. Loss aversion: Individuals are afraid of losses. Research shows that losses of a given magnitude create more pain than the pleasure derived from gains of the same magnitude – by a factor of around two. Mental shortcuts driven by loss aversion regularly undermine the ability of individuals to stay focused on longer-term goals.
3. Hindsight bias and overconfidence: Hindsight bias is where individuals believe they predicted an event when in fact they had only considered it a possibility. It often reinforces over-confidence which leads to an unjustified belief in an individual's ability to predict the future. Overconfidence frequently expresses itself in individuals believing they can correctly time buying or selling investments at the bottom or top of the market. Yet, after they transact, the price often continues in the same direction.
4. Confirmation bias: Confirmation bias is where individuals have a tendency to accept information that confirms an already-held belief. If new information surfaces that confirms their view, it is quickly taken as confirmation, even if the information is flawed, whereas if contradictory information surfaces, they discount it.
5. Anchoring bias: Individuals can be heavily influenced by a reference point or ‘anchor'. Investors might lock onto a particular price of an investment (a ‘high water mark'), or the dollar figure for a portfolio, and disregard other relevant information. For example, it might lead to irrational decisions because they measure outcomes against a number that does not reflect underlying fundamentals. Or they might hold onto an investment longer than they should, waiting for a particular price point.
Better approaches for the longer-term
Fortunately, we are not condemned by our programming. To be successful longer-term investors, individuals need to be aware these biases are at play and take steps to work around them.
One approach is to obtain professional advice. Financial advisers know not to let biases influence their advice to clients. They focus on helping their clients maximise the chance of financial success over time by working with them to define their goals and understand their risk profile, then designing a plan and a portfolio to achieve those goals. Importantly, once in place, the portfolio is regularly rebalanced to the optimal asset allocation, a process which automatically takes into account swings in market prices.
Another approach is to choose a life-cycle investment option, which progressively reallocates investment allocations each year depending on the investor's age. NZ Funds offers an optimised lifecycle investment option as part of some of its investment products.
The NZ Funds investment team also considers Behavioural Finance as part of its intelligent investment approach. It actively seeks to mitigate the downside in a falling market and capture the upside in a rising market. One tool it uses is the Universa Black Swan Protocol which acts like an insurance policy to offset violent market sell-offs.
These approaches can give investors the confidence to stay the course, whatever the market environment, and achieve longer-term financial success.
Source: MSCI All Countries World Daily Total Return Index (Global Shares), Bloomberg, NZ Funds calculations.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
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Stephan Clark is Chief Client Officer for New Zealand Funds Management Limited (NZ Funds) and a member of the NZ Funds KiwiSaver Scheme. Stephan's comments are of a general nature, and he is not responsible for any loss that any reader may suffer from following it.
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