Investors behaving badly: five mistakes and tips on how to avoid them

28th September 2017 by Darius McDermott

We all like to think we are rational and considered investors, but in reality, most of us fall into at least a few behavioural traps. We are only human after all…

Here are five examples of behavioural investing mistakes and some tips (and funds) to help you avoid them.

  1. Anchoring

This is when we fixate on one piece of information to the detriment of others. For instance, one thing we’ve all been guilty of recently is assuming that interest rates are so low, the only way is up. I, for one, have avoided bond funds for this very reason. But interest rates have stayed low and bond funds have continued to make money.

Fidelity Strategic Bond follows a multi-strategy approach that seeks to add value through a large number of sources. The manager doesn’t shy away from discussing both the good and the bad areas of his asset class. He has the experience to navigate the complex waters of the fixed interest market and he has been able to generate returns (and an income stream) with low volatility by selecting the right asset allocations for the majority of the time.

  1. Herding

This is when investors ‘follow the crowd’ – choosing a particular investment because everyone likes it. It plays on our instinctive ‘safety in numbers’ assumption – that if other people are buying, it must be a good investment. An extreme example of this was  the bubble, when everyone piled into technology stocks just at the wrong time. Going against the herd can be very difficult and uncomfortable though.

Investec UK Special Situations has been run by renowned contrarian investor Alastair Mundy for more than a decade. This fund aims to deliver capital growth by investing in unloved UK companies that the manager believes are undervalued. The manager’s approach tends to be especially successful during turning points in investor sentiment when investment fashions change.

  1. Confirmation bias

Sometimes we hear a ‘hot tip’ from a friend, or perhaps see good one-year return figures and we make up our minds straight away that it is a good investment. When we dig a little deeper, we then have the tendency to filter information selectively to back up our opinion. Professional investors can be susceptible too: fund managers run the risk of being on the lookout for information that supports the investment case rather than seeking out information that contradicts it.

Jupiter Absolute Return’s manager describes his process as “floppy”, by which he means he likes to be flexible in how and where he can invest, although this word belies his strongly mathematical approach. He welcomes challenge and debate amongst the team that supports him and uses three screens to analyse stocks over three different time horizons and will prepare for several different scenarios and analyse how his portfolio might react in each case.

  1. Overreacting

It is all too common to see investors pulling their money out of investments when markets go down, crystallising losses. It’s understandable, as these are often important savings and it’s hard to watch their value decline. But it can also be a costly overreaction. Thinking long-term and avoiding day-to-day market noise is key.

Matthews Asia Pacific Tiger’s team is deliberately based in San Francisco, rather than Asia, in order to avoid the short-term ‘noise’ of the markets. The team like to take a very long-term view and ideally a stock will then be held within the portfolio for many years. It is a high conviction, low turnover portfolio with an emphasis on domestically or regionally-oriented companies that stand to benefit from the long-term evolution and growth of the Asian consumer.

  1. Overconfidence

One of the biggest dangers comes from human overconfidence. I saw a nice reminder about this from Aviva Investors recently who cited some research by Dresdner Kleinwort Wasserstein analyst James Montier back in 2006, which found that 74% of 300 fund managers surveyed thought they were above average at their jobs while the majority of the remainder thought they were average. John Maynard Keynes also famously remarked it is “better to be roughly right than precisely wrong”.

Aviva High Yield Bond fund has a higher risk of a company not being able to pay its debts than a fund investing in higher quality bonds, but it has not experienced a single default over the past three years. While the manager obviously has very good stock-picking skills he remains very down to earth and approachable and is far from being on a pedestal. He said recently that, “as opportunities increase, a healthy dose of scepticism will be required to achieve my objective of avoiding losers while generating income”.

Of course, there are some funds that actively look to avoid all of these issues.

M&G Episode Income, for example. The term “episode” in its name refers to those periods of time when investors’ emotions cause them to act irrationally. The fund manager uses behavioural finance to find pockets of value and invest against the herd rather than following it.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.