Helping clients with the behaviour gap

Problem behaviour

Markets have historically rewarded patient capital, but most investors fail to capture these returns due to poor timing decisions, a phenomenon known as “the behaviour gap”.

This refers to the practice of investors buying after prices have already risen and selling after they have fallen, transforming market volatility from a potential opportunity into a source of loss.

Many studies have found that average investors underperform the index because of this behaviour. Perhaps the most striking example of this comes from Fidelity Investments where Peter Lynch managed the Magellan Fund between 1977 and 1990, producing an annualised return of 29.2 per cent. Yet it has been reported that the average investor in his fund made only 7 per cent per annum (Jakab, 2016).

The chart below showing fund inflows and market performance during the Global Financial Crisis is another illuminating example. As equity markets declined through 2008, fund outflows accelerated dramatically, reaching their most negative levels during 2008-09. Outflows continued even after markets began recovering, with flows remaining negative through 2011 despite substantial market gains during this period.

Behavioural biases

To cope with the daily information overload, our minds rely on mental shortcuts or rules of thumb called heuristics. While these shortcuts serve us well in many aspects of life, they can also lead to cognitive or behavioural biases that are problematic for investing.

• Confirmation bias causes us to seek information that supports our existing beliefs while ignoring contradictory evidence. An investor convinced of a company’s potential might focus on management’s optimistic guidance while dismissing customer complaints, executive departures or deteriorating financial metrics.
• Overconfidence tricks us into believing we can predict outcomes with greater certainty than we actually can. This might manifest as an investor who has enjoyed success with a few stock picks becoming convinced they can time market cycles, leading them to make increasingly concentrated bets or using leverage.
• Loss aversion makes losses feel more painful than equivalent gains feel pleasurable. This asymmetry leads to seemingly irrational behaviour: holding losing positions for too long (hoping to “break even”) while selling winners too quickly (to “lock in gains”).
• Hindsight bias convinces us we “knew it all along” after events unfold, preventing us from learning from our mistakes. An investor might remember being “cautious” about a failed investment when their notes actually show they were highly confident at the time of purchase, preventing honest post-mortems that could improve future decision making.
• Groupthink emerges when teams prioritise harmony over critical thinking. Investment committees might reach consensus not because the analysis is sound, but because challenging the prevailing view feels uncomfortable.
• Recency bias leads us to overweight recent events when making decisions. Investors often chase last year’s best-performing asset class assuming recent trends will continue indefinitely. This backwards-looking approach systematically buys high and sells low, as yesterday’s winners often become tomorrow’s laggards.
• Herding makes us feel comfortable following the crowd, even when the crowd is heading towards a cliff. The Dutch tulip mania, the South Sea Bubble, and the housing bubble all shared a common thread: rational people making irrational decisions because “everyone else was doing it”.

These biases often work in combination, amplifying their individual effects. Recency bias might lead an investor to chase last year’s hot sector, while confirmation bias ensures they only read bullish research, and overconfidence convinces them to make an oversized bet. When a reversal eventually comes, loss aversion prevents them from cutting losses quickly and hindsight bias ensures they learn nothing from the experience.

How to help clients

Experienced advisers understand clients often need help with the psychology of investing and the biases outlined above. We have often heard that “psychologist” should form part of an adviser’s job description!

One way that advisers can help their clients is by suggesting a set of rules to minimise the potential impact of biases. One simple approach is to have a mutually agreed investment or trading plan in which the adviser and client agrees to a set of rules – optimally in writing – around what they will (and won’t) do in certain situations, like minimising selling following a sudden price drop or minimising the amount of the portfolio allocated to stocks with lots of positive sentiment and price momentum.

We also believe assessment of successful investment decisions warrants equal attention to less successful. As professional investors we try to evaluate the quality of our decisions rather than judging success according to outcome. This distinction helps us learn from both wins and losses by focusing on whether our analysis was rigorous and our reasoning sound, rather than results that may reflect luck or short-term market movements.

Bottom line

We all have biases, and behavioural finance shows this certainly exists for investors of all levels of experience and confidence. For clients wanting guidance with their investment decisions, astute advisers can add significant value “beyond the numbers” by recognising unhelpful instincts and helping avoid common traps.

Kris Webster, principal at Canopy Investors