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Curb your
behaviour - how can your behaviour affect your investment and what can you do about it?

Our viewpoint

Have you ever been winning all day at the races, feel like you are immune, taken another bet and wiped out all your gains? Conversely have you ever began losing – panicked and instead of coolly calling it quits, proceed to continue in the hope you can make it all back with one risky bet – nope, wipe out!

I’m sure if you are reading this you have heard of terms like ‘market risk’, ‘credit risk’ and ‘stock-specific risk’ Have you though considered behavioural risk? Perhaps this should be the first risk you consider. There is an old saying ‘financial markets are driven by two powerful emotions – greed and fear’. Though the saying has long been around, the study of behavioural impacts on finance is newer, beginning in 2002 when Daniel Kahneman (an award winning psychologist) was awarded the Nobel prize for economics.

It is hard for us humans to admit our faults, and so we do frequently make the same mistake twice (I refer you to repeated economic crisis, debt crises, corporate failures). Behavioural risk continues to loom large, even though it does not fit neatly into any of our conventional economic models of risk and return.

Now back to managing a pension scheme - thankfully there is regulation, and the trustee model in place to curb the worst behavioural tendencies and prevent wipe out. A well funded scheme can afford to de-risk and protect capital whilst ensuring their assets are generating enough returns to meet liabilities. For the weakest schemes there are safe guards in place and the PPF.

However, there are always efficiencies that can be gained by properly considering behavioural risks, and situations with bad behavioural dynamics can result in a lot of wasted time and sub-par decisions. For example, have you ever hired a manager with stellar performance only to have them underperform for the next few years. Or have you ever fired a manager, or divested from an asset class then painfully watched as performance recovered?

There are sometimes good reasons to replace managers, but these should be driven by fundamentals, I’m sure you’ve all seen the disclaimer ‘past performance is not a guarantee of future return’. It is important trustees understand the asset classes and managers they invest in and potential ups and downs to avoid selling an asset class/manager at exactly the wrong time. For example, if you are an emerging market investor you should expect some potentially outsized gains and losses at times and a solid return over say a ten year horizon. You should also expect returns to differ markedly from a global developed portfolio – emerging markets routinely go through periods of returning below a developed market index.

Have you participated in long and tortured debates on currency hedging, interest rate hedging or rebalancing where it became less and less clear what you should do? We’ve certainly seen all of these behaviours play out over the years. For example, some schemes have not implemented LDI due to the low rate environment in the hope that rates rise, reducing the scheme’s liabilities. In recent years, the most important determinant of how well a scheme is currently funded has been how much LDI they've had in place. The rational view to take is that interest rate risk is unrewarded therefore should be mitigated.

Studies have shown informed groups can make better decisions (than an individual) in certain environments – however it is critical that each member voices their opinion, and more often than not that doesn’t happen, which can make groups worse. If you have a group that is dominated by one or two very engaged individuals you may end up with a strategy that only reflects the beliefs of a couple of people. This could be, for example, riskier than needed if the person has an appetite for risk. It is therefore important to encourage open debate so that decisions are reached by consensus, factoring in everyone’s opinion and the specific information that they hold and others might not.

How can we help? Here are a few ideas:

  1. Checklists. Yes, the humble checklist, beloved of the airline industry, can help us here by forcing us to think systematically through a number of steps, which can help avoid getting overly influenced by only one factor and keep our emotions in check.
  2. The pre-mortem. Whenever you invest in something first go through the exercise of imagining you are analysing its bad performance a year later (not where anyone wants to be, but always perfectly possible, however good for the investment).
  3. The decision log. Clearly recording the key reasons you made an important decision for the scheme and monitoring these over time to ensure they still remain valid, or whether a change is needed. After all, nothing is forever except change.

Ways to counter these group biases:

  1. Write down individual opinions on a matter, read out all opinions and discuss each one.
  2. If a member of the group is not voicing an opinion, ask them!
  3. Ensure the group has diverse perspectives, ie not all from the same company’s division, town or educational background, so that they can bring a different view point to the table. Studies have show that firms with diversified boards: by gender, culture and ethnicity have outperformed their peers. A big part of our role as investment consultants is to help minimise behavioural bias and ensure decisions are taken as objectively as possible
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