The better angels of our nature

Why we are our own worst enemies when it comes to investing?

angel praying

It is a familiar caricature: the devil on one shoulder and an angel on the other. When investing, we often struggle to work out which adviser to listen to. Take investing for the long term. That such a simple message gets forgotten so often is prescient. We panic. When it comes to the crunch many investors forget the basic benefits of being invested for the long term. Lessons like compound interest, the perils of market timing and not following the herd go out the window.

By way of reminder for each. According to a study by research group CLSA1, with the same contribution levels, a saver who invests from 21 until they are 30, and then stops, will have a slightly bigger pension than someone who starts at 30 and saves until they are 70. The extra ten years for compound interest to do its thing works out as more powerful than the additional contributions made by the 40-year saver.

When markets tank it is generally the swift bounce back that provides much of the subsequent returns

Similarly, we have all read about just how few days make up the bulk of equity market returns: the logic being that when markets tank it is generally the swift bounce back that provides much of the subsequent returns – so if you miss one, you typically miss the other.

And when it comes to asset bubbles, they are a crude representation of our worst characteristics: fear, greed and laziness. In the modern world of 24/7 news flow this fear can be exacerbated by scary headlines such as ‘huge losses’ and ‘markets plunge’. If we allow the fear to take over it can prevent us from taking the necessary investment risk to achieve our financial goals. At worst it can lead us to selling our entire portfolio and going into cash – when staying put would have been the better decision.

So why do we continually forget such basic lessons and concepts?

The core of the issue stems from our biological make-up; the way in which our brain, specifically the amygdala, processes information. It stands to reason that we would create mental short cuts, or heuristics, to help deal with the flood of information we get bombarded with on a daily basis; the alternative would be paralysis. But as intellectual giants like Richard Thaler and Daniel Kahneman have so forcefully laid out in behavioural economics terms, cognitive biases, while useful, can often lead us astray.

One of the worst biases, loss aversion, has its roots in our cave-like tendencies. It made sense for our hunter-gathering forbears to be overly cautious: one mistake could mean falling prey to a predator. Similarly, with no certainty of when or where the next meal was coming from, storing fat was a biological advantage; yet now we are surrounded by cake, it seems less so.

Doing the harder thing

Walter Mischel’s now infamous Marshmallow Test2 – whereby children are given the choice of one sweet now or two sweets later – is perhaps the neatest expression of why thinking, and more to the point behaving, with a long-term perspective is so important. Those children who chose to postpone gratification tended to have better life outcomes, as measured by educational attainment, body mass index and wealth-related measures. Thankfully, however, our fates are not all determined at birth, or even crystallised in our early years; nature and environment can play a part and we can correct some of our foibles.

Knowledge and awareness are not enough on their own. At the last count, Wikipedia lists over 200 cognitive biases.

Debiasing is only possible via incentives, nudges and training, all of which we can do ourselves. 

A combination of simple rules like buy and hold  mixed together with increasingly sophisticated technology-based techniques can help investors a great deal

A combination of simple rules like buy and hold (and don’t constantly check on performance to help overcome framing bias), mixed together with increasingly sophisticated technology-based techniques can help investors a great deal. In terms of the latter, Greg Davies of Oxford Risk talks about decision prosthetics being required – i.e. set up your environment for making choices in a way that supports doing the right thing. This means tailoring attitude-to-risk measures and even communications in a far more personalised way.

For many, this approach to overcoming innate biases could manifest itself as buying an appropriate risk-managed multi-asset fund and simply shutting one’s eyes for a few years.

Key risks

Investment risk

The value of an investment and any income from it can go down as well as up and can fluctuate in response to changes in currency exchange rates. Investors may not get back the original amount invested.

Derivatives risk

The fund uses derivatives; these can be complex and highly volatile. Derivatives may not perform as expected, which means the fund may suffer significant losses.

Important Information

This commentary is not an investment recommendation and should not be viewed as such. Except where stated as otherwise, the source of all information is Aviva Investors as at 08 October 2018. Unless stated otherwise any opinions expressed are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature.

Portfolio holdings are subject to change at any time without notice and information about specific securities should not be construed as a recommendation to buy or sell any securities.

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