DOING well with money is not so much about how smart you are but more about how you behave, author Morgan Housel writes in The Psychology of Money.
While many investors are well-informed about different regions, sectors and asset classes, they may be unaware of the unconscious motivations and biases that are likely shaping their investment decisions.
Money – and investing – is strongly linked to emotions, including fear, shame and anxiety. When these so-called “survival-mode emotions” kick in, our body signals that we may be in danger.
This evolutionary-wired “negativity bias” means that people tend to pay more attention to negative inputs than positive ones. It also implies that investors may be swayed more by negative emotions – to the detriment of their investment portfolios.
Wealth managers – ourselves included – are paying more attention to such biases and behaviours.
Our disciplined investment process, which has evolved over many decades, aims to take emotions such as fear and shame out of decision-making, so that we can focus on the realities of today’s market environment rather than bias-driven narratives.
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As the global economy and financial markets have embarked on a fundamental transition, it is timely to explore a few behavioural biases that underscore the importance of a strong investment process in managing our clients’ wealth through this reset.
Dare to diversify
I will start with the home bias, which can stand in the way of building long-term wealth.
Some investors prefer to allocate most – or all – of their equity or fixed income allocation in their investment portfolio to local assets.
Home bias investors appear to act on the assumption that local financial markets will go up every year, which clearly does not reflect the reality of investing.
This is because investors feel more comfortable investing in something they think they know better as they believe it will yield higher returns.
In doing so, however, they create a more concentrated and less diversified portfolio that brings its own risks.
By focusing only on the local market, an investor may have exposure to just a few sectors, which could lead to cluster risks if there is a downturn in one industry, or if a home-grown giant runs into issues.
Another issue for local-only investors is that they cannot benefit from growth in other sectors that are underrepresented within their home indices. For example, financials account for half of the MSCI Singapore Index, followed by the communication services (16.1 per cent) and real estate (15.7 per cent) industries.
In contrast, consumer staples, consumer discretionary and information technology all account for less than 5 per cent of the index.
While investments in foreign assets do bring risks such as currency fluctuations, possible political and regulatory turmoil, as well as additional costs for transactions, taxes and hedging, they can be managed as part of an optimised strategic asset allocation (SAA).
We view the SAA as the backbone of a robust and diversified investment portfolio, including of the delegated portfolios that we manage.
While there are good reasons for our clients to invest in their home market, it is also important to help them understand the benefits of greater diversification through foreign assets.
Look to the long term
Other behavioural biases appear during periods of stress in financial markets.
An example is the significant sell-off in equities last year, as the global economy exited the lower-for-longer interest rate environment and entered a period of higher inflation and interest rates.
While we now see opportunities in bonds as inflation has peaked, we expect equities will continue to struggle amid the lacklustre, low-growth economic backdrop.
Of course, most investors will feel some anxiety when the markets are solidly in the red. But behavioural biases may lead them to take an action that they may regret.
For example, hindsight or experience bias based on past downturns may lead investors to expect the same outcome.
Another bias is myopic loss aversion, in which investors feel a greater sensitivity towards losses than gains, look frequently at their (declining) investments and cannot endure short-term fluctuations.
This may cause people to sell all of their investments in a declining market, even if they end up taking a loss.
This phenomenon is well documented: cognitive psychologists Daniel Kahneman and Amos Tversky found that “losses loom larger than gains”, with the pain of losing thought to be psychologically about twice as powerful as the pleasure of gaining.
A related bias is the disposition effect, which persuades investors to hold on to specific loss-making assets such as a single stock for too long because divesting them would feel like admitting to a mistake.
On the flip side, investors tend to prematurely sell assets that have gained in value.
But a more rational investment strategy – especially for building long-term wealth – may be to sell the losing stocks and hold on to the winning ones.
Discipline and diligence above all
Such biases pose a real challenge for investors.
How can they keep a level head in a time of turmoil – or euphoria – in financial markets?
The SAA again holds the key; it is, in fact, the most important contributor to a portfolio’s success.
This is why investors need to understand the importance of sticking with that long-term strategy, come what may.
After all, when it comes to achieving long-term investment objectives, what counts is time in the market, not timing the market.
Some investors might find this easier to do this by delegating the management of their investments to a trusted adviser.
The benefit here is that the investment decisions are determined not by a single individual but by a global investment committee.
At Credit Suisse, for example, we make our decisions based on the input of our research, investment strategy, economics and portfolio management teams. The outcome of this collaboration is a bank-wide “house view” on the global economy, financial markets and themes and trends.
As we have learned, successful long-term investing is not just about finding the best investment opportunities, but the capacity to navigate difficult biases and emotions during periods of stress.
We expect the investing environment will remain tough for the foreseeable future.
Passive investment approaches may be less effective than in the recent past as the era of low volatility and high returns is over.
As active managers, there will be undoubtedly difficult investment decisions ahead.
However, we believe that an approach built on disciplined processes that avoid – or at least mitigate – behavioural biases helps to deliver the best outcome in all environments.
The writer is global head of investment management at Credit Suisse
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