Investment: Money and madness go hand in hand
People's emotions are powerfully engaged by money: the average investor approaches investment decisions in the same way that most people approach food
Wednesday 24 February 1999
Unfortunately, this kind of aberration is more common than we realise. The most solid, sober citizens are just as prone to blindness in the face of monetary symbols as the psychologically disturbed.
How do we know this? Partly from observation of the world around us. Why does such a large proportion of the population still finance their houses with an endowment mortgage, which is clearly not the most sensible way to proceed? Why do millions play the National Lottery every week? Why are Internet shares trading at such absurd multiples of non-existent earnings?
No doubt we all have our own theories for this strange behaviour. But actually we don't need to fall back on observation or our own pet theories for an explanation. It so happens that behavioural science has started to take an interest in the subject of investors' attitude to money and the trade offs between risk and return which are central to every decision we all have to take about money. Their studies are starting to throw up some interesting observations about the way that people behave in this respect - and one of their central findings is that irrationality is indeed part and parcel of the process.
I am indebted to Ken Fisher, a fund manager on the West Coast of the United States, for the following summary of the latest state of play in the research. As well as being a successful investment manager in his own right, Mr Fisher is also an accomplished author of several books on investment, and a longtime student of the behavioural aspects of finance. Like many other others who look after other people's money, he has learnt that logic, reason and consistency, are not always what the clients of fund managers are after.
For example, it is common for people to hire fund managers on the basis that they are looking for someone who can outperform the markets over time. However, if the markets run into a bad patch - say they drop by 15 per cent - and the fund manager manages to limit the fall in the investor's fund to 10 per cent over the same period, quite often the fund manager still gets fired. He has achieved the client's objective, but the client is working to a different agenda.
The same phenomenon, let it be said, applies just as well as to those high level managers who act as trustees of your pension fund: for years, trustees instructed their pension fund managers to outdo the market averages by 2 per cent a year, despite the overwhelming evidence that this objective is next to impossible to achieve over periods of more than a year.
The underlying reason for all this is that people's emotions are powerfully engaged by money. In Ken Fisher's view, the average investor approaches investment decisions the same way that most people approach food. "Just as we want taste, nutrition, low cost, appearance, convenience and prestige with our food, so too with investments we crave: high positive returns, prestige (peer superiority), low cost, convenience, active packaging, low volatility, a lack of embarrassment and much more".
His point is that investment engages multiple objectives - and therefore creates the scope for serial disappointment. Risk for most investors, on this view, is not just the risk that they will lose money; it is a much wider panoply of disappointments. Missing any one the investor's multiple goals is a cause for regret - and therefore, more often than not, the trigger for irrational behaviour as a result.
Some well-known research by two behavioural psychologists, Richard Thaler and Shlomo Benartzi, has shown that normal people are very lopsided in their attitudes to making and losing money; in general, they are two and a half times more upset by losing pounds 1 as they are pleased by gaining pounds 1. (This in the jargon of the profession is known as "myopic loss aversion").
A related phenomenon to this is that investors are also often dissatisfied (even though they have achieved their objectives) if they have got there by a route which is not quite the one they expected. Fisher gives the example of someone who has a portfolio of shares and bonds. He has bought the shares in the hope of gain and bought the bonds as a defensive mechanism. Now suppose that over the next period, share prices fall and the bonds rise, leaving the investor overall no worse off than before. The strategy of diversification has worked - but most people in those circumstances, the evidence suggests, will still be upset because things have not worked out as they planned.
Yet another human emotional failing in investment is over-confidence. This is particularly true of men, apparently. Studies of the trading results of groups of men and women have repeatedly shown that women are much better traders than men. The underlying reason is that they are less confident about their ability to beat the markets, so they trade less often. One study showed that men trade 45 per cent more often than women and achieve an annual return which is 1.4 per cent per annum less.
And what sort of market conditions bring out all the worst of our emotional responses? The answer is obvious when you think about: it is market declines like the one we experienced last summer and before that in 1987. Even after years of strong bull markets, the average (male) investor still takes a 20 per cent drop in the markets really hard.
Because of the 2.5 to 1 loss to gain ratio, it feels like a drop of 50 per cent. He is desperate to pass the blame on to someone else and, through over-confidence, equally determined to take his portfolio into his own hands and trade his way through to a better outcome.
- 1 I've been called an abusive and dangerous parent, when all I did was listen to my transgender child
- 2 Migrant crisis: Greek soldier saved 20 people singlehandedly off Rhodes beach
- 3 Sofyen Belamouadden murder: The inside story of a crime that horrified Britain
- 4 Company breaks open Apple Watch to discover what it says is 'planned obsolescence'
- 5 UK weather: Britain braced for snow as arctic air mass moves in
Migrant crisis: Greek soldier saved 20 people singlehandedly off Rhodes beach
Russian hack of President Obama's emails worse than previously admitted
Aaron and Melissa Klein: Oregon anti-gay bakers ordered to pay $135,000 after refusing to make cake for same-sex wedding
UK weather: Britain braced for snow as arctic air mass moves in
Nepal earthquake: US Pastor Tony Miano sparks outcry by suggesting Nepalis should convert and not rebuild their 'pagan shrines'
General Election 2015: Chuka Umunna on the benefits of immigration, humility – and his leader Ed Miliband
The sickening truth about food banks that the Tories don't want you to know
Migrant boat disaster: Ukip candidate mocks victims in sickening Twitter post
Nigel Farage wants the BBC to stop making programmes like Doctor Who, Strictly Come Dancing, and Top Gear
Global warming: Scientists say temperatures could rise by 6C by 2100 and call for action ahead of UN meeting in Paris
General Election 2015: Britain would become a 'communist dictatorship' under Ed Miliband and Nicola Sturgeon, claims wife of Michael Gove
iJobs Money & Business
£20000 - £22500 per annum + OTE £30K: SThree: SThree Group have been well esta...
£24000 - £26000 per annum + benefits : Ashdown Group: A highly successful, glo...
£50000 - £55000 per annum: Ashdown Group: Business Analyst - Financial Service...
£18000 - £23000 per annum + OTE £45K: SThree: At SThree, we like to be differe...