Does gut instinct betray us when it comes to investing?

If you’re wondering why you often get the timing of investments wrong by buying at the top and selling at the bottom, you might be glad to learn that you’re not the only one. It’s human psychology, and understanding what kind of an investor you are, and how you are likely to behave when faced with certain choices, might just save you some money.

"It stems from the fact that the financial decisions that are optimal for the long term are often very uncomfortable to live with in the short term," says Greg Davies, head of behavioural and quantitative finance at Barclays Wealth in London.

The problem is that few of us can follow super investor Warren Buffett’s mantra, “be fearful when others are greedy and greedy when others are fearful”. This means that as a result of getting hurt so badly in the most recent crash, many investors have missed out on the recovery.

“That reluctance is very much a feature of having been through a bad patch. People say, ‘I’ll sit on the side until I’m comfortable again – but you won’t feel comfortable until well after the fact,” says Davies, pointing to the numbers of investors around the world who have been sitting on piles of cash, waiting for the right moment to get back in. Meanwhile the markets have soared.

Composure
To bridge the gap between how a rational investor should behave and how human nature can cause us to act in reality, behavioural finance has stepped into the breach, offering a framework for investors to overcome their deeper instincts.

Wealth manager Barclays has developed a financial personality test, based on six six stable personality attributes that distinguish one investor from another. These range from risk tolerance, to perceived financial expertise, to composure.

“Someone who has low composure is very emotionally engaged with the present and has a more emotional response that leads them to be more likely to seek comfort along the journey,” says Davies.

If you find yourself ringing your financial adviser the minute you hear the latest on deposit guarantees in Cyprus or crashing Japanese markets, this could be you. If you are such an investor, beware your potential downfall.

“Typically (those with low composure) give up long-term performance to seek short-term comfort,” says Davies.

If, on the other hand, you’re happy to sit out any fluctuations and volatility in the markets – and may not even be aware of them – you have “high composure”. However, this can also be problematic.

“Someone who is really high (composure) can be far too blasé; they can be too laid back and don’t pay enough attention,” says Davies.

“The best investor is someone who’s on the middle of these things - any form of extreme behaviour can open you up to risks”.

If you can’t change your personality, you can create an investment framework that hedges against your core instincts.

“If you’re essentially a low composure investor, you should try and put yourself at arm’s distance from your investments. You need to look at returns less frequently, and to pay attention to overall performance without digging into the detail. It’s not about what you buy, but about how you watch them. The more you can get up to 36,000 feet, and the greater the distance, the better,” says Davies.

“Most individual investors should be less close to the detail than they are. Our ability to predict in the short term is pretty negligible.”

But what about the recent collapse in Japanese stocks, you might ask. Wouldn’t an investor have been better off being aware of this and being able to respond immediately? Not so, says Davies. While acting quickly can sometimes be of benefit, it won’t “outweigh the 40/50 times you were better off doing nothing”.

For the high composure investor, who’s too busy or preoccupied to pay too much attention to his or her investments, restructuring their approach can help.

“For such an investor, using a discretionary manager can be good,” says Davies. Those who don’t like to delegate their investments to a fund manager or adviser should set up a series of alerts – reminding them, for example, to examine their portfolio on a certain day of the month.

“Over time it becomes a habit and you don’t leave decision making until it comes to the surface of your mind.”

Costs of emotional investing
Understanding your financial personality and learning to work around it can offer financial rewards, says Davies.

“There is evidence that the average investor probably costs themselves 2-3 per cent per year – because they’re responding to their emotional needs,” he says. A hefty price to pay for being able to sleep at night – or is it?

For many investors, not enjoying the potential returns from a high risk investment is a reasonable price to pay for having one less stress in their lives. Davies argues that the question is how much you’re willing to pay for that level of comfort.

“If you’re giving away 3 per cent a year because that’s the decision that you’re comfortable with – could you get that comfort with just giving away 1 per cent a year? It could be a win-win situation,” he says.

In striving for such comfort at a lower cost, Davies recommends investments in which the short-term volatility is smooth – so investors should either look for active managers, or funds where there is a derivative overlay.

“You’re still paying for this comfort – but less than 2-3 per cent,” he says.

Taking such an approach “won’t eliminate your emotional needs”, but it will “assuage them more cost-effectively than your knee -jerk responses will do”.

Herding
Composure also comes into play in the "herding" effect. It's all about the fear of missing out.

The market is starting to pick up, your own sentiment has started to improve and you’re hearing about successful investments friends have made. Staying in cash and treading water on your investments no longer seems enough. So do you follow the herd or stay true to your own investment goals?

“It’s part of the reason why it’s so comfortable to invest when you hear people at cocktail parties talking about how much money they have made,” says Davies. However, “people naturally tend to react to what other people are doing in a detrimental way”.

His advice is to do the opposite to what people are recommending. “If you’re going to listen to other people you should err on the side of being a contrarian.”

However, he concedes that for most people, this is not something that feels comfortable (property boom anyone?).

“So, unless you’re actively waiting to play the contrarian, for the most part it’s best to ignore what other people are doing and dampen that emotional response,” he advises.

But which personality type makes the better performing investor?

“[Being] the best investor is less to do with your personality and more to do with [whether you have] taken the time to think about who you are, and taken the steps to put in place a framework that matches your financial personality.”