Investment: Self-knowledge is the key to success
Wednesday 05 May 1999
The importance of temperament was certainly one of the conclusions that emerged two years ago when I carried out an in-depth study of what it was that made the small handful of exceptional UK professional investors stand out from the crowd.
This is reinforced in Profits without Panic, a new book by Jonathan Myers, a New York psychologist. He pulls together the various strands of research that have tried to link the way people invest with the way they control their emotional and behavioural responses to money.
Few of us are blessed with temperament and self-discipline to do exceptionally well at investment.Neither, so it happens, are many professional investors. We are allsubject to mental biases that lead us to make what Mr Myers calls "systematic errors" - many of which are easier to understand than they are to cure.
Pointing out that even the likes of George Soros make huge gaffes from time to time, he quotes Niels Bohr's definition of an expert: "A man who has made all the mistakes which can be made in a very narrow field."
Here is one example of how wayward investors can be: a psychologist at Harvard University, Paul Andreassen, studied whether two groups of investors behaved differently. One was presented with simulated news stories that attempted to explain why a market or share price had risen, while the other group was not.
Which group did better? Thegroup without any information. They tended to buy as prices fell and sell as prices rose, relying purely on the value of the bargain they were being offered.
The group with the advantage of the news coverage was far less successful. They traded less accurately because they regarded the explanations they read in the news coverage as validating the way in which prices were moving, rather than merely describing it.
Anyone who has worked in daily newspapers will know that it is virtually impossible to avoid attributing a sharp movement in the market to some external cause, such as the Asian crisis or the opinion polls. You have to find good news to justify a rise, and bad news a fall, even though the explanation is invariably more complex than a simple good/bad juxtaposition suggests.
A similar problem arises with what psychologists call "preferential bias", the phenomenon by which once something about a potential investment has caught your eye, you tend to look for information that validates your initial feeling and ignore evidence that might point you in the opposite direction.
This, suggests Myers, might be why, having become interested in, say, a unit trust with a good performance record, investors so often ignore the fact that it also has exorbitant sales charges and commissions that effectively wipe outany advantage the superior performance bestows.
This would certainly help to explain why the introduction of "reduction in yield" illustrations on pension policies and unit trusts seem to have made so little impact on investor choice since the introduction of compulsory disclosure a few years ago.
And then there is the "hot hand" phenomenon, identified in research by Kahneman and Twerski, which demonstrated that even professionals continued to believe in trends that they had observed but which had no statistical validity. The research was conducted into basketball, where participants all believed that players in the middle of a long run of scoring (a "hot hand") were more likely to score than to miss with their next shot.
Yet the statistical evidence clearly shows that this is not the case. It is an illusion, as is the "hot hand" concept in fund management.
Faced with all this evidence, how are you to survive? The answer, says Myers, is to control your emotions and become aware of what you can and cannot realistically hope to achieve in the investment world.
Those who get that far can then try and profit by exploiting the evidence of other investors' mistakes (by selling popular fad stocks, for example, and buying shares suffering from a surfeit of public gloom - Marks & Spencer being a classic recent example).
The trouble is, of course, if it were really that simple, we would all do it. At the moment, in particular, the markets seem to be suffering from a clear case of what Myers calls "stability bias". This is the tendency for people to assume that if something persists for a number of years, it somehow becomes a reliable norm. The recent strength of Wall Street and to a lesser extent the UK market is a classic example of this phenomenon.
Equity returns cannot continue at their current levels in real terms; even Jeremy Siegel, the American professor whose book emphasising the consistency of long-run equity returns helped to set the great US bull market running, now says as much.
But is anyone really listening? Myers suggests not : "In a bull market internal personal reasons, fuelled by hope, are relied on to account for success and everything else is, consciously or subconsciously, dismissed as irrelevant."
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