JOHN MAYNARD KEYNES once said that “there’s nothing so dangerous as the pursuit of an rational investment policy in an irrational world”. Despite that advice, every day, people try to construct rational, risk balanced portfolios. And often they fail, instead buying what is fashionable, or panicking when they should be cool-headed.
According to Dr Greg Davies, the head of Barclays Wealth’s unique behavioural finance team, the problem isn’t so much that pursuing a rational investment policy is dangerous – it is that it is difficult. “It’s not like there’s ever been any shortage of good advice” he says. “The problem is not a lack of advice, it’s a lack of ability to follow through on it.”
While the financial industry has been hiring physicists and other “quants” for decades to analyse markets, Davies brings something rather new to finance – psychology. In his view, the average investor is self evidently not always the rational “homo-economicus” that classical finance theory assumes. Rather he is human, with emotions and habits, and those can derail any rational investment plan.
Together with his highly academic team (four have PhDs and continue to contribute research), Davies has spent the last four years trying to understand how our human foibles sometimes prevent us from making classically “rational” decisions. The team then tries to provide a personally tailored investment plan designed to account for clients’ emotions.
“We’re not saying classical finance is wrong” he says. “It just lacks the human element. We want to construct portfolios that are right in the classical sense of having the risk-return tradeoffs, but right also in the sense that the customer is comfortable with it, so they’re less likely to make decisions along the way that are detrimental to their long term performance.”
Davies argues that most investors have an inbuilt tendency to “buy high and sell low”. When investments are doing badly, and so cheaper, people are wary of putting money in – they fear regretting it. But at the top, “when all your friends at the dinner party are telling you how well they’ve done, it flips over – suddenly it’s fear of not doing something”.
People put their money in, and then the bubble bursts. Davies points out that not only did individual investors pour money into stock markets at the peak of the boom, and so lost out most in the crash, they also failed to benefit from the recovery in Spring 2009. Instead the gains flowed mostly to institutional investors who were able to put aside their fears.
EMOTIONAL DECISIONS ARE COSTLY
According to a study Barclays commissioned from the Cass Business School, emotional decision making costs the average investor 1.2 per cent of performance per year – hardly insignificant. More importantly, the distribution is quite wide – so some investors lose an awful lot more.
Realising that, Davies divides his clients into two groups – high composure and low composure – through a simple profiling test. High composure people can deal quite well with the ups and downs of investing, and so they are advised to get traditional, risk balanced portfolios. Davies’ interest is in the low composure individuals – people said to have a “high emotional involvement with the short term,” or more simply, the anxious.
Low composure people tend to find losses very distressing and to get overexcited by short run gains. Consequently, they are more likely to make bad decisions, especially during intensely emotional periods like financial crises.
For those people, Davies has a few strategies. He compares his clients to Ulysses faced with the beautiful but deadly sirens. But whereas Ulysses tied himself to the mast of his ship to avoid the deathly lure, Davies is more reluctant to lock investors in. “The people who are most nervous, most engaged with the short term, are the ones who when they find themselves locked in, are most distressed by it,” he says.
Instead: “We structure your portfolio in a way that throws oil on the waters,” smoothing out the ups and downs of the market. Or alternatively: “We can help to try and get you to sleep through the waves” by distancing clients from their portfolios, and so helping them see the “bigger picture.”
BUILD UP GOOD HABITS
But portfolio structure isn’t everything – habits matter too. Davies reckons that one of the reasons why institutional investors do better than individuals is because they have to adhere to a strict set of rules. “Nick Leeson and Jerome Kerviel are the exceptions that prove the rule – when professional traders get around this, they can cause more damage than any individual.”
Davies never trades intraday on his own account – he always waits until the end of the week. He also only trades in areas he knows a lot about. “It’s like writing a constitution for yourself – you’re allowed to change the constitution, but only when you have a supermajority.” According to Davies, building up good habits is the key to avoiding stupid emotional decisions.
And with financial markets and confidence now gradually recovering, Davies is expanding his ambitions a little further. He argues that the importance of distinguishing between long term and short term decision making is fundamental to other areas of life – including government and corporate management.
“Our natural, emotional, institutional structures are all geared towards the short term.” As a result, people from politicians to corporate managers tend to be judged on their short term performance, to the detriment of long term decision making. That helps cause crises, exacerbate problems that could have been planned for and otherwise makes the world a less controlled, reasonable place.
But while Davies’ team might help you make your investment strategy a little more rational, they can’t do much about the irrationality of the entire world. Unfortunately enough, on that at least, Keynes might still be proven right.
CV | DR GREG DAVIES, BARCLAYS WEALTH
From: Born in Cambridge but grew up in Johannesburg
University of Cape Town
● BBusSci in philosophy, economics and finance
University of Cambridge
● MPhil in economics
● PhD in decision theory and behavioural finance
● Guest lecturer at the London School of Economics
● Honorary research fellow at University College London