Dan Miles

Investors often rely on mental shortcuts and biases to manage their investments but these can result in poor decision-making and behaviour that can have a long lasting impact on their finances; advisers have an important role in helping clients  overcome these biases and improve decision-making, according to a new research paper from Innova Asset Management.

Dan Miles, Managing Director and Co-Chief Investment Officer of Innova, says decisions grounded in biases can be very problematic for investors, especially when they’re related to important issues such as managing money.

“Behavioural biases often translate into poor investment performance, and this paper, Portfolio construction: avoiding bad behaviour, A new era approach to defining and aligning risks to individual investment goals, uncovers the important role financial advisers have to play in helping Australians better manage their money in a more objective way and to not be overcome by their emotions or biases,” he said.

Despite how practiced we are as decision makers, most of us are notoriously bad at them, straying away from the rational, fact-based frameworks of textbooks, and instead being influenced by a range of factors, including our emotions, our biases, and our mental bandwidth, the research paper finds.

“Financial advisers can and do play a vital role in coaching and mentoring their clients to help them make better decisions and avoid value destructive behaviours.”

One of the biggest drivers of poor decision-making is sheer mental overload, and the short cuts people adopt to make decisions, according to the paper. The paper reveals that investors can often be overloaded with information and decision-making. Humans make around 2,000 every hour.  While many of these decisions are low level decisions of little consequence, such as what to wear or what to eat, some decisions are much more serious, and can have a significant impact on relationships, careers or investments.

“Scientists estimate the human body sends 11 million bits per second to the brain for processing, yet the conscious mind can only process around 50 bits per second. And the mental load is only increasing. Scientists estimate we process at least five times more information today than we did 40 years ago. The digital age may have its upside, but it also creates a state of almost constant distraction and struggle to focus,” the paper says.

“The only way we can cope is to use mental shortcuts or heuristics to make decisions amongst this deluge of data. These are our behavioural biases.”

Amateur investors, in particular, or those who rely on their own resources, are particularly prone to making poor decisions, and these can result in consistent investment underperformance.  “Sometimes investors overestimate their own abilities, believing that they are smarter or more informed than they really are. Associated effects can include poor stock selection, increased risk taking, and more frequent trading of stocks, all of which can drag down portfolio performance. Various studies have shown men are more likely to exhibit overconfidence than women,” the paper reveals.

Other common biases include the anchoring bias, which causes investors to rely heavily on the first piece of information they are given about a topic and interpret newer information from the reference point of our anchor instead of seeing it objectively. “In a broader context, investors can also be anchored around other reference points, including individual stocks, regions, performance benchmarks, and even individual CEOs, all of which can undermine objective decision making,” the paper says.

According to the research paper, by better aligning individual goals with an investors’ risk tolerance levels and constructing differentiated portfolios to reflect these goals and risk tolerances, clients gain more ownership and understanding of their investment strategies, helping to avoid nasty surprises and minimising the likelihood of value destructive behaviour.

“Creating better investment behaviours among clients requires financial advisers to use a framework that is robust, repeatable, and scalable,” Mr Miles said.  “Best practice analysis has identified three key elements in such a framework. First, aligning and prioritising investment goals around client values, second, applying risk benchmarks that better reflect client behaviours and market dynamics and are tailored to individual goals, and finally, promoting client financial literacy,” Mr Miles said.

The paper stresses that using a broader range of risk metrics when constructing portfolios beyond volatility is important. “Volatility has traditionally been the most common measure of risk used by advisers. But for all its merits, it also has its limitations. Although volatility can be positive or negative, it treats all outcomes the same. Volatility doesn’t reflect all the risks that can face an investor, such as the risk of not generating enough capital growth and due to misconceptions in the way volatility is calculated, many people falsely believe that two investments with the same standard deviation are equally risky,” the paper finds.

“As well as utilising a more comprehensive view of volatility – which reflects its limitations, a broader range of risk metrics could include the maximum drawdown a portfolio could bear; the average magnitude of drawdown, and the frequency with which a significant drawdown might be expected. Using such a range of risk benchmarks would allow scope to build portfolios more closely aligned to the way investors cope with risk in the real world and build portfolios that maximise growth potential without breaching risk comfort zones,” the paper says.

Setting investment goals aligned with an investor’s values are important too. “In an investment context, we are likely to be more disciplined and focused on pursuing goals that are grounded in our values, where the emotional link is stronger. From an adviser’s perspective, determining a client’s values is therefore critical.”

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