Classical versus rock'n'control

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Classical finance assumes people are rational and that once an individual works out their optimum investment solution, they can both implement it and also persevere with their strategy. Hence the idea of a "rational portfolio", that optimally trades-off taking on more risk for the prospect of a higher return. Typically investors are advised to build a rational portfolio, which means including a selection of asset classes combined in such a way as to achieve the best possible returns over the long term, whilst taking an amount of risk appropriate to the investor.

Life would be dull if we all looked the same 4 of 8 Executive summary 2 of 8

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

Please read this important information before proceeding.

From a behavioural finance point of view, the classical approach to finance has some major flaws. The central argument of behavioural finance is that we are not perfectly rational, and we do not have perfect control even over our own behaviour. Instead, our decisions are shaped by our context, emotions and a number of psychological biases that we are unavoidably prone to. It is quite daunting to think that there are so many variables that can interfere with our ability to implement and stick to our investment strategies over the market cycle.

Rationality Fails Us...

One of the difficulties we have as investors is what we might call "failures of rationality," which makes it very difficult for investors to do the right thing as prescribed by classical finance. Failures of rationality in investing behaviour can perhaps be best divided into four categories, as follows.

Failing to see the big picture
We are all subject to what psychologists call "narrow framing" - we consider decisions in isolation, without looking at the big picture. We therefore tend to focus on investment decisions one by one, without considering the impact on our overall portfolio. This could mean we miss out on diversification opportunities, make new investments that cancel out existing ones, or decline opportunities that look too risky on their own, but would be a good addition to the overall portfolio.

Using a short-term decision horizon
We also consider and make decisions narrowly based in time. We base our decisions on anticipated performance over short time periods, when what matters is growing our wealth in the long term. To put this in perspective, the MSCI world index1 posts losses about 40% of the time over any given one-month period. However, over a one-year period the probability of a loss drops to 25%, then down to 19% over five-year period, down to 7% of the time over a 10-year period, and almost never over 20-year time frames. When we focus on the short term, which we are prone to doing, we are potentially misleading ourselves. As Greg Davies, Head of Behavioural and Quantitative Finance at Barclays explains: "All humans are prone to loss aversion – the tendency to feel the pain of a loss about twice as strongly as we feel pleasure from an equivalent gain. Since the proportion of losses we observe increases when we use shorter time periods, loss aversion means our willingness to accept risk is much lower when we focus on the short term than it should be. This common feature of investor behaviour is known as 'myopic loss aversion.'"

Buying high, selling low
The issue here is comfort, we all tend to take more risks when we are comfortable, and fewer when we are not. The problem is that we tend to be comfortable when markets have been rising for a while and when we have been surrounded by good news. We are uncomfortable when we have been through times of stress and chaos. Unfortunately this means we are likely to take on more risk when markets are high, and less when they are low. In fact, we would be better off to buy and hold.

Action bias (trading too frequently)
Several of the biases discussed above lead to an action bias. Our failure to focus on the big picture leads us to make small, frequent decisions. If market conditions are volatile, we will trade to feel like we are doing something about the market deviations (buying high and selling low, and focusing on the short term). The more you trade, the higher your costs, and the higher the chance of making decisions that are emotionally driven or based on market noise. Most of the time the best advice is simply to do less than you are inclined to.

 ...and Emotions Confuse Us

These failures of rationality are not the only ways our behaviour can be shaped. Our emotions, combined with a tendency to act on short-term preferences, can also lead us to act in a way that, in hindsight, might seem irrational or illogical.
Short-term preferences and emotions can also lead to a number of more specific investment failures. Some examples of the ways this can manifest itself in an investment context include:

Anxiety about potential short-term losses without recognising that if you take a long-term view of your portfolio, there is an increasing probability of investment gains. This may prevent people from entering or staying in the market during times of poor market conditions.
Trying to strategically time the market and ending up paying for it. Instead of buying low and selling high, our emotions tempt us to do exactly the reverse.
A tendency to buy asset classes that we feel more familiar with. Emotions make us feel safer in asset classes we are more comfortable with; for example, many have a preference to invest in their home markets even though we thereby lose many benefits of diversification.2
After losses people often stay out of the market for too long - being burned in the past leads us to be more cautious in the future.

Supporting the disruption caused by these emotions, Dr. Thorsten Hens, Head of the Banking and Finance Department at Zurich University, comments on the wisdom of sticking to a long-term investment strategy, such as rebalancing, rather than allowing short-term emotions to guide our portfolio management: "A rebalancing strategy keeps the proportions of assets in the asset allocation, e.g. 60% stocks, 25% bonds and 15% commodities - balanced over time. Rebalancing is good since in the long run, markets are mean reverting - what goes up must come down. Hence, when one rebalances, one buys when cheap and sells when markets are expensive."

However, he warns that emotions can sabotage well- laid plans. He suggests that recording emotions can help investors deal with them without reacting to them: "Emotions are fundamental in investing: greed, fear, regret, surprise and anger are all triggered while investing. The investor should accept these emotions because they help us to learn faster."

The result of these distortions is, as Dr. Neil Stewart, Professor of Psychology at Warwick University, points out, that: "Homo Economicus, the rational decision-making man, does not exist." As a result, we do not naturally have the skills to make sensible decisions, in finance and elsewhere: "The brain is mainly set up for wandering around on the savannah picking up berries; we’re stuck with that sort of Stone Age brain, trying to do modern financial decision making with it. Basically your brain is doomed."

Intangible Complications Have Tangible Effects

This lack of control over our emotions is not an abstract problem; in fact, it can have tangible, detrimental effects on both investor satisfaction and performance. A recent Dalbar study into investor behaviour found that over 20 years, ending December 31, 2010, the average equity investor earned 3.8% a year, while the S&P 500 index returned 9.1% annually - a considerable difference. This effect was also found in a study commissioned by Barclays at the Cass Business School from 1992 to 2009, though the results were more conservative. The total return of UK equity funds was 6.5% but the average investor earned only 5.3%. Compounded over 10 years, this difference is significant – it is a sacrifice of nearly 20% of one's return.

Similarly, a lack of self-control is linked to lower financial satisfaction. Our global study of 2,000 high net worth individuals asked investors whether they wanted greater self-control in their financial management. Those who did want self-control were less likely to be satisfied with their financial situation, as we can see in Chart 2. Note that this relationship is not simply because those that have financial discipline are wealthier. Those who wish they were more disciplined are less satisfied, even when income and net worth are taken into account.

The Trading Paradox

A particularly damaging failure of financial discipline is overtrading or trading too frequently. Many studies have confirmed how this can cut into returns. The annual returns of the most active traders (top quintile) are 7% lower compared to the least active traders (bottom quintile) - an effect attributed to overconfident trading and neglecting transaction costs.

Our data also reveals an interesting pitfall on the theme of "emotional trading", which can tempt investors to buy high and sell low, which can cost nearly 20% in lost returns over a 10-year period.5 This tendency leads to the trading paradox. A third of those polled (32%) say that trading frequently is necessary to get a high return, however these respondents are over three times more likely to believe that they trade too much. In total, almost half (46%) of respondents who believe you have to trade often to do well think that emotions force them to do this.

Our survey asked the following three questions about trading behaviour to understand the extent to which investors trade too much:

  • To do well in the financial markets, you have to buy and sell often (trade often).
  • I buy and sell investments more than I should (trade too much).
  • I try to strategically time the market rather than adopting a buy and hold strategy (attempt to strategically time the market).

Chart 3 shows that 32% of respondents believe that frequent trading will result in better performance. The chart also shows that 40% actually do this, either because they believe they have to or because they believe even if you do not have to, it is nonetheless beneficial.

The paradox starts to emerge when we asked about trading too much. On average only 16% of respondents believe they overtrade. However, those who believe that trading frequently is an effective strategy are over three times more likely to believe they trade too much, and nearly 50% of traders who are sure you have to trade often to do well think they overdo it!

So why do so many of us believe that frequent trading is beneficial in the first place? On the face of it, you might think that those who were trading more actively would be more experienced, sophisticated and able to control themselves, but that seems not to be the case - trading becomes addictive. So one basic problem is that investors may feel they need to engage in active trading, but they cannot then control how much they do it.

Overconfident trading was highlighted earlier in this report as one potential reason for trading too much. Dr. Chun Xia, Assistant Professor of Finance in the Faculty of Business and Economics at The University of Hong Kong, explains overconfidence and its effect on trading in more detail: "Overconfidence basically says that most believe their ability is above the average or their information is more precise than the average, which are simply impossible. For example, if I ask my students, 'Do you believe your score on the final exam will be above the average?' more than 80% of students would say, 'Yes,' which is impossible, because only 50% of students can outperform the average.

When people believe they have a higher ability than the average, or more precise information, or more accurate interpretation, then what they will do is to buy or sell with a larger amount than optimal. Basically, they trade too much. However, if they trade too much, then they pay more commission, and they push the price to a level against their interest, so the return will be reduced. This is a very simple, well-established fact: investors trade too much."

Dr. Xia proposes a number of explanations for this overconfidence. One is "self-attribution bias" - the willingness to attribute good investment decisions to yourself, but bad investment decisions to others. Another problem is that, because the feedback from the markets can be very cluttered, it is difficult to tell whether you have made a good investment or a bad one in a short period. Overconfidence can also make investors reluctant to hire investment professionals.

Overconfidence basically says that most believe their ability is above the average or their information is more precise than the average, which are simply impossible.

Interestingly, Dr. Xia's research also confirms previous findings that women trade less - but could earn more than men (see next chapter for gender differences in investor personality). We also observe this pattern in our global survey of wealthy men and women. Chart 4, on the opposite page, shows men are more likely than women to try and strategically time the market instead of simply buying and holding. Yet men must have some indication that this is not an effective strategy - or at least that it is one that they take too far. They also are more likely to admit that they trade more than they should


Men are not the only demographic group that admit to buying and selling investments more than they should. Our survey also found that having more money to trade with leads one to trade too much, as 20% of those in the highest net worth category (£10m+) say they trade more than they should compared to 14% in the next category (£2m - 9.9m). Again, this effect can be attributed to a higher willingness to take on risks in wealthier populations.

The Desire for Discipline

If we attempt to follow a "rational" path but lack self-control the effects are clear: we will overtrade and we will buy high and sell low. As a result, we will be both less effective investors and less satisfied investors.

In order to prevent this we need to take steps to facilitate our efforts to exert self-control – as Ulysses tied himself to the mast, or his crew filled their ears with wax, we need to find ways of constraining our own future behaviour in times of stress or uncertainty. Greg Davies at Barclays explains that: "This can only happen if we give something up: this could be our ability to respond with knee jerk reactions, or it may mean sacrificing a small amount of the performance of the 'rational' portfolio, in order to ensure that we have a portfolio with which we're emotionally comfortable in the short term. These sacrifices would be unnecessary if we were rational robots – but as humans these small constraints or sacrifices can help prevent much larger costs to our performance or satisfaction."

This self-control is made harder due to the pervasive nature of familiarity in investment decisions.Dr. Barbara Fasolo, Lecturer in Decision Sciences at the London School of Economics believes familiarity plays a big role in investment decisions in general. The hypothesis being that familiarity leads to overconfidence, which in turn fuels a perception of expertise in a particular investment area.

Dr. Annie Koh, Associate Professor of Finance and Dean of Executive Education at the Singapore Management University, further illustrates that familiarity bias plays a fundamental role for some investors, whose comfort in one asset class is such that they avoid diversification of their portfolio.

"There are people whose comfort level is so strong with one asset class, such as property or currencies, that they do not practice the diversification rule. We have a very rational rule in diversification, every business school professor will tell you to diversify and yet I have seen many investors, and even wonderful colleagues, who are investing only in a particular asset class because that's where they feel they make the best decisions."

Barclays's Greg Davies discusses how familiarity with one's own country can lead to "home bias" - a reluctance to diversify out of local markets and engage in the global economy: "This tendency can actually increase risk exposure, even though investing in one's home country may feel safer. Ironically, sometimes a degree of self-discipline is needed to move out of one's subjective comfort zone in order to move to a more objectively secure position."


I think familiarity plays a big role in investment decisions in general, because you tend to be more confident. The problem with overconfidence is that it's fuelled by familiarity. So, the more familiar you are with things, the more overconfident you are that those things will go well.

Thus far, we have focused on the need for self-control to stop yourself from doing something - excess trading or panicked selling with market downturns. This commentary reveals that sometimes it takes self-control to force yourself to do something that feels uncomfortable - diversifying into markets or asset classes that feel unfamiliar.

Self-assessment of behaviour begins with an awareness of the need for greater self-control. Our survey asked investors whether they agreed with the proposition: "I wish I could take a more disciplined approach to my finances", and found that a substantial proportion (41%) agreed with this desire for more discipline. Closer inspection shows that some parts of the high net worth population are more likely to desire greater self-control than others (Chart 6).

Women reported a greater desire for self-control in their approach to financial management. This relationship can be explained in part by lower composure in women (see next chapter for gender differences in investor personality); women are likely to get stressed more easily and their awareness partially accounts for their greater desire for financial discipline. However, it is men who actually have a greater need for discipline when it comes to investment management, as they tend to be overconfident in investing, leading to lower returns, as explained by Dr. Xia.

Age also influences our desire for self-control. Within our group of high net worth individuals, increasing age brought with it a reduced desire for discipline. Age was a factor that showed many differences in the need and desire for self-control and also investor personality types. In fact, with increasing age the wealthy gained calmness and satisfaction in their approach to financial management. This is discussed in more detail in The Zen of Ageing.

Involving others also leads us to believe no greater level of discipline is required. Those who make joint decisions think they need less discipline as their joint involvement itself acts as a means of adding discipline - two minds provide two perspectives, increasing the chance of detecting potentially irrational decisions before they are carried out.
Desire for discipline also changes with source of wealth. Those whose wealth has come from inheritance are aware of a need for discipline, perhaps due to their need to be accountable for the legacy they are managing. Similarly, entrepreneurs and those whose wealth comes from property or large bonuses are more likely to have a high need for discipline, compared to those whose wealth was amassed more steadily through saving income or accumulated investment returns.

1 Analysis over the past 20 years, completed by Barclays.

2 Diversification does not protect against loss.

3 Rebalancing does not guarantee an investor's goals and objectives will be met.

4 Barber & Odean (2001) Boys will be boys: Gender, overconfidence, and common stock investment. Quarterly Journal of Economics.

5 This effect was found in a study commissioned by Barclays at the Cass Business School from 1992 to 2009. The total return of UK equity funds was 6.5% but the average investor earned only 5.3%. Compounded over 10 years this difference is quite significant - it is a sacrifice of nearly 20% of one's return. Many other studies have shown similar results.