Why behavioural finance matters

  • Written by 
Add to my collection

The classical principles of good investing are based on the assumption that we are all perfectly calm, unemotional beings, concerned only with long-term financial objectives. In truth, emotions are the biggest driver of our investment decisions and, therefore, our returns. At Barclays, our experience with behavioural finance gives us insight into two important aspects of investor behavior that can negatively affect returns.

Interest rates, bond yields, and commodity and equ ...5 of 5 Dream and reality emerging 3 of 5

Residents of the United States, please read this important information before proceeding

Please read this important information before proceeding.

Reluctance

The first is reluctance: individuals often fail to see the potential long-term benefit of investing in a diversified portfolio compared to holding cash. This can cost the average investor 4–5% per year of foregone returns, over the long term.

Reluctance is the ‘default’ state of most investors. In normal circumstances we fear taking a risk and getting it wrong, more than missing out. This reluctance to get involved is compounded by another strong behavioural effect: loss aversion. Simply put, when we make decisions, “losses loom larger than gains”7 – we believe we will feel more emotional pain from losing a certain amount than the pleasure we experience from gaining the same amount. This may seem intuitive, but it has huge implications for investors. The proportion of loss we perceive for the same portfolio can be manipulated by how returns are presented to us.

Anxiety goggles
The chart below shows the annualised returns that an investor in the MSCI World Index would have experienced over time, depending on whether they focused on long- or short-term returns. The smoother (blue) line shows a rolling window of annualised 10-year returns. This line illustrates perception of returns along the journey that should inform our decisions. Ninety-six per cent of the time, the 10-year returns are positive; only turning negative in the catastrophically bad times at the depth of the credit crisis.

Figure 1: Annualised returns as seen through long-term and short-term frames

Contrast this with the more extreme line, which reflects rolling 1-year returns, which is much more akin to the actual perceptions of investors along the cycle (which tend to be even more extreme). In general, the same investment can feel completely different depending on the time frame over which we observe it. As evidenced in the diagram, investors experience vastly more volatile returns if they use a short-term horizon; unfortunately, as we all live in the present, short-term is our natural psychological default.

Failing to invest completely is the first way in which we naturally purchase short-term emotional comfort (because we tend to see things through our ‘anxiety goggles’) at a cost to long-run returns. It provides this comfort in a very simple way – you cannot lose if you don’t get involved – but at a very high price. Figure 2 shows the effect of sitting in cash versus investing, over the last 10 years. Even during this turbulent time in the markets, being invested was a clear winner. Indeed, it’s only in the depths of the most extreme crisis in living memory that a diversified portfolio dipped below cash, and as long as the investor didn’t sell in panic, this situation was very short-lived.

Figure 2: The long-term value of diversified investing

Reluctance is the ‘default’ state of most investors

Behaviour gap

The second issue that behavioural finance sheds light on is the behaviour gap. Multiple studies have confirmed that the average investor underperforms a simple buy-and-hold strategy over long periods of time. Most credible research on individual (as opposed to institutional) investors finds this underperformance to be between 1% and 2% per year, on average (although this can be substantially higher). And the behaviour gap is purely attributable to market-timing decisions, not costs or fees.

A recent study by Cass Business School – which used data from investors in actively managed UK equity funds over a 20-year period – concluded that, relative to a buy-and-hold strategy, the average investor conceded 1.2% annually by moving in and out of funds.8 This percentage may not sound like much, but it amounts to a significant difference in final wealth when compounded over 20 years. If we take the 1.2% gap and apply it to $1mm invested in a hypothetical Diversified Portfolio. An investor who
invested $1mm in a moderate-risk diversified portfolio would have $4.44mm after 20 years.9 A behaviour gap of 1.2% per year would, over two decades, reduce this to $3.50mm – a difference of $940K or 21%.10

Although overcoming reluctance early is one of the keys to better investing, investors usually incur costs relative to the long-term optimum through being too active with the wealth they do invest. They do this by over-trading, constantly trying to adjust their portfolios and take advantage of perceived patterns in the market, and by increasing risk when they feel comfortable, but decreasing it when they feel uncomfortable.

One famous study grouped real investors into five groups according to the proportion of their portfolio they turned over every month. The bottom group barely traded at all, while the top group changed nearly 25% of their portfolio every month. Results were in opposite proportion to how much investors traded: The less they traded, the better they did.

Figure 3: The behaviour gap and active trading

Behavioural finance helps us to understand why investors deviate from good investing practice: Because good long-term investment decisions are invariably uncomfortable along the way. At Barclays, our behavioural finance approach is not to ignore this human need for comfort, but to acknowledge it and ensure that we can help each of our clients achieve it as efficiently as possible. Only by having a practical system that addresses investors needs for emotional comfort along the journey will investors be able to endure the ride, and get to the end with the sort of returns they should.

7 From the famous 1979 Prospect Theory paper of psychologists Daniel Kahneman and Amos Tversky, which later won Kahneman the Nobel Prize for Economics (Tversky had passed away by the time the prize was awarded). Kahneman, D.; Tversky, A. (1979). “Prospect theory: An analysis of decisions under risk”. Econometrica 47 (2): 263–291.
8 Study commissioned by Barclays at Cass Business School, Clare & Motson (2010). “Do UK retail investors buy at the top and sell at the bottom?”UK equity funds from 1992 to 2009 recorded by the Investment Management Association.
9.Source: DataStream and FactSet. Diversified Portfolio is represented as the following mix of indices, all in US dollars: 7% - Barclays US Treasury Bill; 4% - Barclays Global Treasury; 7% - Barclays US Corporate Investment Grade (1 Jan 1992–31 Dec 1996), then Merrill Lynch Global Broad Market (1 Jan 1997–31 Dec 2012; 11% Merrill Lynch USD High Yield & Emerging Market Sovereigns (1 Jan 1992–31 Dec 1998), then Merrill Lynch Global High Yield and Emerging Markets (1 Jan 1999–31 Dec 2012); 38% - MSCI World Index; 10% - MSCI EM Index; 5% - Dow Jones UBS Commodity TR; 4% - Real Estate by FTSE EPRA/NAREIT; 14% - HFRI fund of Funds Composite (1 Jan 1992–31 Dec 1997), then HFRX Global Hedge Fund (1 Jan 1998–31 Dec 2012). The weightings are rebalanced monthly to maintain the same mix over time. Past performance is no guarantee of future results. Changes in indices were made based on availability of historical index data.
10 The return calculated for the hypothetical Diversified Portfolio above does not represent actual portfolios, nor does it reflect trading or the impact of material economic and market factors including fees. Hypothetical illustrations and performance have certain inherent limitations. No representation is being made that any client will or is likely to achieve the hypothetical return represented in the illustration on this page.