Portfolio a mess? You may just be irrational

The study of 'behavioural finance' reveals private investors are prone to bizarre decisions, says Stephen Spurdon

Imagine you are on the therapist's couch being probed about the motivations behind your investment decisions. Chances are that for many of us this would be as uncomfortable as being asked about other elements of our personal lives, and our answers would reveal the heart ruling the head more often than not.

Imagine you are on the therapist's couch being probed about the motivations behind your investment decisions. Chances are that for many of us this would be as uncomfortable as being asked about other elements of our personal lives, and our answers would reveal the heart ruling the head more often than not.

But just how rational are your investment and other personal finance decisions? In many cases something may have seemed a good idea at the time, but when you review your investment portfolio the haphazard pattern could be embarrassing. It may also reveal how often you bought unthinkingly into "flavour of the month" shares or funds at the top of the market. Following the herd is the most obvious example of illogical investor behaviour, but it is a very human instinct not to want to be the odd one out.

About 70 per cent of the UK's private investors admit that their investments are a mess, says a recent survey conducted by MarketMinder for ISIS Asset Management. It found that 13 per cent of investors did not even know what they were invested in.

All these examples of apparently bizarre activity are increasingly coming under a new microscope labelled behavioural finance. This is a branch of economic psychology that compares actual investor behaviour with the alleged purely rational approach dictated by classic economic theory.

This field of study grew from the development of prospect theory by two Princeton University professors as long ago as 1979. Their research revealed that we are more distressed by losses than we are made happy by equivalent gains, and are more prone to taking risks to avoid losing than we are to realise gains.

By the time one of these academics, Daniel Kahneman, won the Nobel prize for economics in 2002, behavioural finance had established itself in the US and was filtering into the British personal finance industry. It is believed that the UK Treasury is looking into this field, although it has yet to confirm its interest.

If you cannot trust yourself to be disciplined enough to create the right portfolio, can you rely on advisers and fund managers to be so? Two US-owned fund managers, Fidelity Investments and JP Morgan Fleming, claim to have integrated the concept into their investment process and eliminated some of the factors identified by behavioural finance.

David Cowdell, a Fidelity director, says: "We do not market-time. The bottom-up stock-picking techniques Fidelity has used for a long time mitigate against the problems identified by the behavioural finance practitioners." Michael Hughes, product manager in European Equities at JP Morgan Fleming, claims that reliance on broker estimates means a less than objective investment process.

He says: "It has been shown that brokers tend to adapt their expectations according to what has already happened in the market. So they adapt to reality rather than predict. This is human psychology affecting markets and that does not change. We use a computer model to eliminate the behavioural finance elements in ourselves as much as possible."

Fidelity also holds seminars for advisers, briefing them on common investor behavioural characteristics and how to counter them.

The personal finance industry, however, is more noted for appealing to our weaknesses in the search for a quick buck. The financial scandals of recent years over endowment policies, pensions, spilt-capital investment trusts, technology shares and funds and precipice bonds show the industry is all too willing to pander to investor fear and ignorance.

Jason Butler, an adviser at Bloomsbury Financial Planning, says that a large part of the problem is how the financial services industry panders to the worst characteristics in investors.

He says: "Many managers are influenced by financial pornography - media stuff, whether adverts or some items published in the media, that is driven by the sales mentality rather than the financial planning mentality."

However, the fund manager M&G used awareness of behavioural finance to change its approach to marketing.

Phil Wagstaff, M&G's managing director for UK retail, says: "We decided to tackle investment issues head-on rather than sell product in our advertising. We changed our style of advertising to become more educative."

During this process, Mr Wagstaff realised he had deceived himself into thinking that he could pick the right time to invest.

"I admit that I used to invest my annual Isa allowance in one go when I thought the time was right," he says.

"But I have taken my own advice and now invest regular amounts throughout the year. It is time in the markets, not timing, that is the thing." The first step towards overcoming behavioural finance hang-ups is to take the "talking cure" of seeking an outside opinion such as an independent adviser or fund manager.

But as a number of experts observe, in such situations investors tend to attribute success to their own infallibility and failure to the adviser or fund manager.

Vin Bhattacharjee, is head of business development at Barclays Global Investors, one of the world's largest global investment companies, and first encountered behavioural finance while studying for his economics degree two decades ago. "We were trying to understand consumer behaviour in a study of energy conservation," he said. "We looked into consumer reluctance to use energy-efficient appliances. These involve a larger upfront outlay, so the consumer was less focused on the longer term savings. The implication was that to get a larger take-up there would have to be a subsidy to finance the purchase."

Now working in the City, Mr Bhattacharjee sees behavioural finance as an important analytical tool. He says: "At BGI we tend to use it to understand herd mentality such as why the market as a whole favours one stock over another, and how much this is driven by what other people in the market are doing at the time, rather than basing decisions on objective news or information."

He says that the vogue for guaranteed products such as so-called precipice bonds is a prime example of how investors can focus on one aspect of an asset while completely ignoring the wider picture.

Mr Bhattacharjee points out: "Fairly obviously, people have an aversion to losing money, so the use of the term 'guaranteed' was attractive.

"And because of what they saw as a guarantee, they were prepared to miss out on some of the upside. But why pay for a guarantee over the long term when the probability of capital loss over longer terms may be lower. Behavioural finance explains why investors take this attitude." He adds: "Ultimately, the Holy Grail is to find prescriptive tools."

Perhaps in the light of our propensity to the irrational it could be argued that we should hand over control to something as emotionless as a computer. However, even computer programmers have their blind spots and, whatever the results, they still have to be interpreted by humans.

FACT FILE: INVESTOR PSYCHOLOGY

* Regret aversion: In the past 25 years, statistical evidence has been amassed to show how people behave. It is from this research that the fundamental concepts underpinning behavioural finance have been developed.

We are five times more likely to sell a share or fund that has done well than to sell one that has done badly.

We tend to hold losers and even buy more, while selling winners. This is called regret aversion (sometimes called "the disposition effect").

* Prospect theory says people who have lost are inclined to be more risk-seeking than those who have made gains.

* Fundamental attribution error describes how when people do well with an investment they think of themselves as being shrewd judges, but when things go wrong they look elsewhere to find the cause. We can all fall into the trap of taking the credit when things go well, but blaming others for failure, a classic fundamental attribution error.

* Anchoring: We identify an investment too closely with the price we bought it for. So although it has fallen, we tell ourselves it will eventually rise back. Investors tend to assume a particular share price is correct or normal. This means each new price or value is anchored by its proximity to the last rather than the buyer considering the long-run averages and probabilities and changes in the fundamentals of a business.

* Confirmation bias: People claim to be objective, but select only the evidence that confirms their hypothesis.

* Systemic error bias: We tend to forget our bad decisions but remember the good ones. Thus we filter out or discount bad news about an investment rather than face up to it. Can be a powerful factor when combined with regret aversion.