Traditionally, behavioural finance has focused on biases. Every propensity we have as investors to act irrationally has had a label attached to it — optimism, bias, recency bias, confirmation bias, and so on.
But some behavioural scientists are starting to question whether the focus on biases and irrational behaviour is a helpful one. Another, and arguably more constructive, way of looking at how investors behave is to focus on our need for comfort.
Investing is intrinsically risky — after all, it’s market volatility that drives the equity premium — so there will always be a degree of discomfort involved. It is however natural, and also perfectly rational, for people to want to feel more comfortable about investing, or at least to minimise their discomfort.
The problem is that, all too often, they seek comfort in things which, ultimately, will only add to their unease. A classic example is the notion that we can enjoy the upside of an investment without being exposed to the downside. It pushes all the right emotional buttons, which is why the industry likes to tempt investors with it, but it’s actually an illusion.
Another example of a false comfort is herding behaviour, which is the subject of the latest part of our video series, Your Own Worst Enemy. In the video, Greg Davies, Head of Behavioural Science at Oxford Risk, explains it like this:
“If I’m making a decision that makes me feel uncomfortable, one of the things that makes me feel more comfortable is that there are lots of other people running in the same direction. The more people that follow the herd, the bigger the herd gets, the more it gives us comfort.
“The problem when it comes to investing is that people like you are probably doing a whole lot of very stupid things.
“We have to actually step away from the herd. Try to find a way of looking in the other direction. Be the contrarian. Be the person who’s willing to swim upstream.”
The term “contrarian investing” usually refers to the assets people invest in. So if most people are buying Security A and selling Security B, the contrarian does the opposite. But another way to view contrarianism is in terms of behaviour. Most investors trade too much, and they buy and sell at the wrong times. If you, on the other hand, can keep trading to an absolute minimum, stick to your chosen asset allocation through thick and thin and, crucially, resist the lure of the latest fad, you give yourself a huge advantage.
But refusing to join the stampede is only half the story. To be a contrarian, you also need to carry on investing when others aren’t. In the words of Warren Buffett, “you need to be greedy when others are fearful.”
In the video Greg Davies refers specifically to 2009, when stock markets had more or less halved in value as a result of the global financial crisis.
“If there was ever a time to get into the markets,” says Greg. “it was then. And yet, every morning you opened the newspaper, there were scare stories about how it was all going to get worse. This was a feeding frenzy — media feeding on itself — and of course, it made everyone else scared.
“There were a few people who bought shares at that point, but most people said ‘I’ll just wait a little’. Every rational, dispassionate rule of investing said ‘this is the time to put your wealth to work’, (yet) very few people did.”
Of course, everything seems so simple with the benefit of hindsight. But it certainly wan’t easy at the time to keep on investing when hardly anyone else was.
It’s at critical times such as those that having a knowledge of financial history, an automated investment strategy and a good financial adviser provide genuine comfort.
At some stage in the future — nobody knows when — we’ll find ourselves in a similar situation. Just make sure you’re prepared for when we do.
Your Own Worst Enemy is a series of six videos. Part 5 will go online at the beginning of January. If you missed any of the first three parts, you can catch up with them on the RockWealth YouTube channel.
ROBIN POWELL is RockWealth’s Head of Client Education. He blogs as The Evidence-Based Investor.