by David Macdonald, Sales and Marketing Director of VAM Funds
Biases affect everyone, from day-to-day activities driven by behavioural patterns to the judgements we make about people and opportunities. These same behavioural biases also guide investment decision-making. Emotional processes and individual personality traits can complicate investment choices, making it more than just analysing numbers and strategic asset allocations. Ignoring or failing to grasp the effect of these biases can have a detrimental influence on portfolio performance.
Emotional bias means that investors often take action based on feelings rather than facts. For example, overconfidence can result in severe consequences for both the returns and risk that investors are exposed to. Being able to recognise the limitations of this bias and taking steps to overcome it is imperative to get the best returns you can. This is why many investors choose multi-manger funds.
Confidence is key…or is it?
Being confident is often thought of as a positive attribute, but confidence can sometimes be a hindrance, rather than a help, when it comes to investing. Overconfidence can occur when individuals overestimate both the quality of their information and their ability to act on it at the right time for maximum gain.
Research has shown that overconfident behaviour can result in excessive trading and poor investment returns. Many of these types of investors will chase overestimated returns, whilst underestimating the risk attached to some assets. As a result, they could be exposed to high levels of risk when making investment decisions. There is also evidence to show that overconfidence can lead to poorly diversified portfolios, making investors more susceptible to volatility.
Overconfidence is intensified when combined with confirmation bias. In the case of investing, this can cause individuals to look for information that supports their idea about an investment, rather than seeking out information that may contradict it.
Reasons for overconfidence
There are several reasons why investors may fall into the trap of becoming overconfident. Recent market conditions have meant that returns in exchange-traded funds have risen, perhaps giving investors the false impression that these high yields are a result of their own skill, rather than the fact they are operating in an upward market.
This success can lead to hindsight distortions feeding confidence levels further. By extrapolating recent experience into the future, investors are in danger of making predictions which may be proven wrong. With the current market conditions and second-longest bull market in equities looking set to continue, overconfidence can become especially problematic. Periods of sustainability like these can often lead to confidence that the prevailing conditions will persist, leaving investors open to risk should the market fall.
Benign market conditions that have led to short-term success through the purchase of ETFs have also fuelled overconfidence in passive investment strategies in recent years. This has important consequences for one of the most important rules of investing – diversification. It is imperative that investors not only allocate across different asset classes and regions, but also adopt a mix of both passive and active strategies.
However, the massive volumes of information which investors are now exposed to is perhaps one of the biggest influences on confident investing. Having access to a multitude of investment guidance websites and online trading platforms, as well as media outlets such as television programmes that focus on the markets, leads to individuals into believing that this information increases their knowledge and therefore improves their decision making, without ever getting professional advice. However, acting upon the advice of these media sources can be detrimental to an overall investment strategy, as it can encourage frequent changes to portfolios, resulting in high trading costs and lower than expected returns.
With bias being an inherent trait within us all, it is important to take steps to overcome it when making investment decisions. Taking professional advice can help to minimise the risk of overconfidence and the effect this can have on an investor’s financial success. One way to do this is to invest through a unitised discretionary fund manager (DFM).
Unitised DFMs offer a range of benefits, most notably access to a range of expert portfolio managers, which allows investors to take advantage of the skills and knowledge of specialist traders. These experts can remain objective when setting trading rules and evaluating investment decisions.
Professional portfolio managers who have expertise within their chosen asset class or industry can use their knowledge about market trends and specific industry news to ensure an investment portfolio is tailored to the investor’s specific requirements. A DFM can then overcome the consequences of overconfidence, such as mediocre returns and higher levels of risk, by making tactical asset allocation decisions which fit with the investor’s investment philosophy, based on facts and market conditions rather than emotion.
Finally, a unitised DFM can ensure that investors are not taking on greater levels of risk than their tolerance for it by creating well-diversified portfolios. As well as access to multiple managers, unitised DFMs often include both active and passive investments, meaning investors limit the possibility of both manager-specific risk and their exposure to risk in a market downturn by ensuring they are invested in assets across different classes and regions using a mix of investing strategies.
Since the financial crisis of 2008, there has been even greater awareness and focus on the discipline of psychology within the financial sector, as investors try to gain a better understanding of bias to help them improve their decision-making processes in selecting investment services, products and strategies. Getting the better of biases such as overconfidence before they impinge on investment decisions is crucial. Whilst this can be difficult, taking advantage of the expertise and diversification which a multi-manager fund, such as a unitised DFM, can bring will eliminate the effects of such a bias on an investor’s overall portfolio.