Globally recognised expert in applied decision science, behavioural finance, and financial wellbeing, as well as a specialist in both the theory and practice of risk profiling. He started the banking world’s first behavioural finance team as Head of Behavioural-Quant Finance at Barclays, which he built and led for a decade from 2006.
In the graph below are three investment journeys. They all start and end in the same place. Without overthinking it, what is your intuitive answer to these questions: Which investor would be happiest with their returns at the end? Which would you rather have experienced?
They're simple questions, with a complicated range of answers.
For over a decade, I've shown this graph to thousands of people all over the world. The answers are remarkably consistent.
About 5-10% pick the green line, with the remainder equally divided between black and blue. Abstaining is also an option, but as near as makes no difference, no one ever picks it. Not only does everyone have an opinion, those opinions tend to be strongly held.
There are myriad reasons to pick each line, the main ones being:
No answer, nor any specific reason for any answer, is 'correct'. There is, however, an answer that is incorrect.
Classical finance asks us to believe the journey does not matter. That is a mistake. Ignoring strong intuitions of the investors who have to endure the journey is always a mistake.
The answers themselves don't matter. The fact that different people see different answers, and that these reflect their personality, does.
In the words of Alain de Botton, “The worth of sights is dependent more on the quality of one's vision than of the objects viewed.” Your investment return comprises both the money and the emotions you attach to its movements along the way.
Asking the question and attending to the answer matters because investing decisions, like all decisions, are ultimately made by our emotions. How happy the three investors are at the end is merely interesting; but the fact that their different emotional states will affect every investment decision they make next is crucial.
When we lack comfort with our portfolio, we will act in costly ways to acquire it. And not all of those ways are created equal. Not investing at all is more costly than paying for an adviser to hold your hand through the journey, which is more costly than simply not looking at your portfolio so frequently.
This is where behavioural science comes in. Until now, looking at personal responses to the journey could only describe what was going on; a proper profiling process turns these descriptions into prescriptions for how to invest better.
Behavioural profiling is important because it allows us to predict in which ways we're likely to make poor decisions, and helps us to avoid them. It helps us to acquire the emotional comfort we need in a cheap, planned, and efficient way, rather than the knee-jerk and expensive methods we tend to clutch at when left to ourselves.
Because ultimately making better decisions isn't just a theoretical exercise.
The graph below shows three real-life journeys that match our theoretical scenarios. In each of the 10-year periods investors received the same returns, and each involved a traumatising market crash, at the beginning, middle, and end respectively. But most important is what's not shown: the investor's emotional state and its longer-term consequences. Despite having substantially increased your money, you would feel vastly different in each case. And you'd make very different, and emotional, decisions as a result.
Investing has after-effects. Early investing experiences can profoundly shape later ones. This makes it even more important to manage bad emotional experiences, in whatever form they're most likely to arise.
Returning to our theoretical journeys, a final lesson is that with some effort we can all turn the green or blue lines into the black one, if we wanted. Simply avert your gaze for the duration of the journey. If a portfolio falls and you're not watching, did it really fall for you?
What you choose to see depends less on the object and more on the eyes you're using to look at it.
Originally published in Professional Adviser on 22/11/2018.
This is the fourth post in a series giving our response to the FCA’s Call for Input on how to apply behavioural finance to help people make engaged investment choices more comfortably and confidently, and what role regulations can play in helping that to happen.Read More
This is the fifth post in a series giving our response to the FCA’s Call for Input on how to apply behavioural finance to help people make engaged investment choices more comfortably and confidently, and what role regulations can play in helping that to happen.Read More