Does gut instinct betray us when it comes to investing?
Understanding how your personality affects the financial choices you make can save you a significant amount of money
A pedestrian walks past a brokerage in Tokyo where stocks fluctuations have affected investors in recent times. Photograph: Reuters/Yuya Shino
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.
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”.