Behavioural biases have become a popular topic amongst the investment community in recent years. A bias, quite simply, is a preconceived opinion or feeling. This leads to another question, where do these biases come from? As we know, our brains are hardwired to take the path of least resistance. Whether or not we are consciously aware, our mind is constantly developing heuristics – a mental shortcut that allows us to make decisions quickly and efficiently. Our brains hardly receive enough credit for making our lives easier! When faced with a decision, our mind creates a default action based on heuristics. It is repeatable. Efficient. These mental shortcuts are derived through years of experience constructed by our upbringing and culture. Our differences in opinion, even compared to our family members, can mostly be explained by our brain’s connection to past experiences.
For example, you may have experienced a negative event growing up. Let us rewind the tape to your first experience eating vegetables – say broccoli. For many, this was not an enjoyable experience. Our brain may have associated the negative taste sensation of broccoli with vegetables in general. When introduced to new vegetables, our brain is likely to tell us it will be a negative experience. Et voila, we have developed a heuristic for vegetables. From an investment perspective, we see the same series of steps that shape our views of capital markets. Another example: most of us remember the Great Financial Crisis of 2008. If you were fully invested in risky assets, you likely experienced a negative return on your portfolio. In fact, a severely negative return. Most investors followed the herd or trend in selling their investments at the low of the market. This experience may have developed a negative association with investing your hard-earned money in the capital markets.
Let’s explore one of the commonly faced biases that has been prevalent over the past year, herd behavior. This is a natural tendency to follow our peers in a certain action or activity. Many years ago, herd mentality was a critical behavioural trait to surviving – you had a better chance of fending off potential threats if you stuck with the pack. In modern society, we do not rely on the same survivorship tactics as we did many years ago; however, the tendency to follow the herd is a common practice. We all remember the apparent need to stock toilet paper in our households at the onset of COVID 19! Despite a lack of information supporting this decision to make it rational, families ran to retail stores to stockpile their household inventory of toilet paper. We followed the herd because it felt safe and comfortable (Kinsted employees that followed this trend will not be mentioned). Within the financial industry, as investors, we seek that same level of comfort or safety by following the crowd. Mutual funds, banks, and insurance companies exploit this behaviour by showing us the best-performing investment products. We can’t help but give in to our instinct of following the majority. In this case, it leads us to chase performance.
The problem with this investment strategy is that market trends go in and out of favour year-to-year. A particular investment strategy that has performed tremendously over the previous 12 months, may not be an indication of future performance (I’m sure we’ve all heard that disclaimer). We recently reviewed a study by Dalbar Inc, a leader in financial services market research, that reviews the impacts of investor behaviour on portfolio returns. What the study has found is that investors consistently underperform both the market and the investment product by trying to “time the market”. This is done by selling an investment product during a period of underperformance and chasing another investment that has demonstrated recent strong performance – in other words, investors tend to buy an investment product after it has demonstrated excellent returns. Unfortunately, after we are lured in by the impressive performance record, the future performance is typically underwhelming.
So how do we counter herd behaviour? Our goal here is not to simply highlight the mistakes we make when our emotions get the better of us. We want to demonstrate tools to counter this behaviour. As it pertains to herd behaviour, we can practice a few tactics that can set us in the right direction. First of all, we need an investment philosophy. This provides the foundation for determining whether an investment is appropriate within your overall portfolio, not just in isolation. At Kinsted, we recognize capital markets move in ebbs and flows. Our investment philosophy is to deliver consistent, repeatable investment returns regardless of market trends or fads. Although previous performance is a consideration in selecting a particular investment, we believe that it does not tell the whole picture. Each investment Kinsted makes is aligned with our investment philosophy of delivering positive performance. Our demonstrated portfolio returns are built using a well-diversified portfolio of multiple asset classes (stocks, bonds, real estate, infrastructure, and agriculture) that can help mitigate the impact of trend performance in the market.
Investor behavior can have a detrimental impact on one's net worth. If you're in need of some support navigating your investment decisions, contact one of our Wealth Counsellors to learn about Kinsted’s approach.