Have you heard sentences beginning with “I would never invest in…”? We never really give these a second thought, yet these may be expressions of some of our most damaging behaviour.
Why do we cordon-off a particular area of an investing opportunity without any rhyme or reason? After all, if we are really in the business of seeking returns, given a suitable risk-return payoff, does it really matter what kind of investment it is?
Let’s look at some of the drivers of these biases.
Fear of The Unknown
A well-known bias is the home bias. For example, a British investor might prefer the more familiar UK fund rather than an emerging market fund, therefore, applying an instantaneous discount to the unfamiliar because of his bias rather than based on the fund’s own relative merit.
In a previous post, “Better The Devil You Know and Diversification“, I wrote,
Perhaps the main obstacle stopping investors from involving themselves in unfamiliar markets is the fact that they lack the knowledge in those markets enough for them to feel comfortable taking the risks. This is known as the Ellsberg paradox, which describes a decision process where it is rational to prefer a lottery with known probabilities to a similar ambiguous lottery where the decision maker does not know the exact probabilities. The English saying for this is, “better the devil you know”.
Fear Stemming from Experience
Another obstacle may be trauma and hysteresis. From their own experience or having witnessed others suffering huge losses from a particular industry may restrain some from considering that industry.
Yesterday for example, brent crude oil hit a fresh seven-year low of $38.90 a barrel. Corporate bonds too, sold off again amidst the closure of a high-yield fund. JNK and HYG fell to their lowest since 2009 as investors took $3.8bn out of high yield bond funds and ETFs over the past week, the biggest outflow in over three months according to the FT.
With these news, I would not be surprised that oil and high-yield bonds would go on some people’s permanent investing blacklist. The technology sector bubble bust still affects some investors, especially those from the older generation who witnessed it first-hand.
Although these fears are all real, emotions are not profitable and even dangerous (e.g. through under-diversification). I would add further to that maxim and propose that to be a good investor one must also put unjustifiable biases aside.
It is worthwhile classifying what constitutes a reasonable preference versus an unreasonable bias. Justifiable preferences would include:
- the ability to earn an excess return for that preference (e.g. information advantage, expertise, low transaction cost),
- selecting based on advantageous risk-profile and effective diversification,
- prudent risk management – mitigation of risks through exclusion is surprisingly effective.
Restrictive mandates would obviously require the holding of certain assets and forsaking some others. Regulation being another reason some would not be able to expose themselves to all of the opportunities available, but these are not bias-based constraints.
Bias on the other hand would arise from:
- merely gaining an emotional and psychological validation for their held beliefs,
- inertia in the face of clearly opposing information (think deer in the headlights),
- reluctance to consider new information or types of investments.
From “The Little Book of Behavioral Investing”, “People tend to underreact in unstable environments with precise signals (turning points), but overreact to stable environments with noisy signals (trending markets)”.
Looking ahead, with experimental central bank policies and the downturn in the global trade, it is more probable that we will be experiencing an unstable environment for a while.
Douglass North, winner of the Nobel Memorial Prize in Economics argued that economic change depends largely on ‘adaptive efficiency’, a society’s effectiveness in creating institutions that are flexible enough to be changed in response to political and economic feedback.
Borrowing from this idea, ‘adaptive efficiency’ for investors is only possible if they have a degree of flexibility to respond to the changes in the investing environment. This flexibility can only materialise if investors have an open mind and not hold unfounded prejudices against certain assets.
In my humble opinion, investors would find it more and more difficult to sit out the troughs of misfortunes their investing biases might bring if they do not adapt their thinking to changes and use all available tools for diversification. This will help them achieve higher and more stable returns.
What is needed is not a complete overhaul of all the wisdom amassed by previously successful investors, but rather a look ahead into the future (as this is what good investors do) and continuous adaptation to the changes in investing.
Perhaps it is a bit presumptuous as well as Darwinian to suggest that those who adapt survive, but it wouldn’t hurt to be more situationally aware and for us to keep abreast of new developments in our investing techniques and environment.