One of the reasons why the investing industry is so large is that investors struggle with a wide range of behavioural biases that cause us to act irrationally. Fund management companies know just the right psychological buttons to press when designing and marketing their products to persuade us to invest.
The UK has a huge financial services sector. More than 1.1 million people work in it, mostly in and around London, and more than 1.3 million are employed in related professional services. A question that is rarely asked is why that is. Why is the industry so enormous?
One reason is that the UK (particularly London) has a longstanding reputation as a centre for global finance. Our geographical location also serves as a bridge between the US and Asian markets, allowing financial professionals to operate across different time zones with relative convenience.
Another factor is that financial services is one of the most lucrative economic sectors. The UK fund management industry, for example, as of 2021, managed around £7 trillion in assets. Finance can also be very lucrative for those who work in it. In a recently published book called The Trading Game, former City trader Gary Stevenson, explains how, by the end of his first year as a trader at a Citibank, he had earned as much as his father had in two decades working for the Post Office.
But there is another fundamental reason why financial services and the investing industry in particular have grown to be so vast, and it’s that human beings have not evolved to be good at investing.
Behavioural psychologists have known for a long time that our evolutionary instincts, while crucial for survival in ancient environments, can sometimes lead to sub-optimal decision-making in the modern world. However it has only been in the last 20 years or so that the connection between poor investment outcomes and the brain’s fast, automatic and intuitive system of thinking has been properly researched.
Behavioural biases that affect investors
Here are some examples of how innate behavioural biases can lead us to make irrational investment decisions:
Loss aversion: Humans are naturally more sensitive to losses than to gains. This can lead investors to be overly risk-averse, and to panic when markets fall sharply.
Confirmation bias: This is the tendency to prioritise information in a way that confirms our pre-existing beliefs. So, for instance, we might seek out reasons to make speculative investments we like the sound of, even though they are likely to underperform.
Action bias: Human beings often feel compelled to act, even when the best thing is to do nothing. Investors typically display this behaviour during periods of extreme market volatility, and they buy and sell at the wrong time.
Herding instinct: Our ancestors found safety in numbers, and we therefore have a deep-seated instinct to follow the crowd, assuming, often wrongly, that it’s the best thing to do. Herding is one of the main causes of financial bubbles.
Immediate gratification: In the past, prioritizing immediate rewards over long-term benefits was often necessary for survival. Today, though, it can undermine long-term financial planning and stop us investing enough for the future.
Overconfidence effect: This is the tendency to overestimate our abilities, and it’s a big problem for investors, particularly young men. It can make us more inclined to speculate and take excessive risk.
Pattern recognition: Our brains are wired to recognize patterns to make quick judgments. So, for example, we see that a certain stock or fund has outperformed for two or three years and assume that the winning streak will continue.
Prediction addiction: Although we live in a complex and unpredictable world, human beings crave a degree of certainty and control. So investors like to make predictions, and rely on the predictions of others, even though it generally leads to poor outcomes.
“A life-and-death struggle”
The financial industry knows all about behavioural psychology. The products fund management companies choose to launch, and the way they market them, are designed to press just the right psychological buttons to persuade us to invest.
So, for example, they pander to our loss aversion by suggesting that their products will reduce our risk, even if it isn’t true. They appeal to our herding instincts by suggesting that such-and-such a fund manager is a star and that we risk missing out on big returns if we don’t join the rush to invest. And they exploit our tendency to look for patterns by presenting us with evidence of short-term outperformance and implying that the trend is set to continue.
Meanwhile, lenders prey on our preference for immediate gratification by persuading us to take out loans or credit cards when, instead of getting into debt, we would be better off saving or investing for retirement.
So the industry knows exactly what it’s doing. It realises that we’re prone to all of the behavioural biases mentioned above, and several more, and that the easiest way to win our custom is to exploit those very same tendencies. The financial industry thrives on its customers’ poor behaviour. In the words of William Bernstein, a neuroscientist turned investment adviser and author, you, the investor, are “engaged in a life-and-death struggle” with the industry.
What you can do about it
What, then, can investors do to stop their behavioural hijacking their investment strategy?
First, become better acquainted with behavioural finance; this video series is a good place to start. Secondly, think about your own behavioural blind spots — we all have them, and, if you think you don’t, that may well be an indicator that you do. And thirdly, develop a natural scepticism about fund management companies; remember, their primary objective is to generate their own fees and profits, not to maximise your investment returns.
Lastly, and most importantly, if you don’t yet have a financial adviser, hire an adviser who understands the importance of investor behaviour; crucially, it has to be someone you can trust, and to whom you feel you can turn if you’re ever anxious about your investments.
Cut yourself some slack
One final thought: don’t be too hard on yourself. None of us is immune to irrational behaviour or to acting on our emotions. Remember, our ancestors developed these instincts over hundreds of thousands of years; it’s completely unrealistic to think you can simply turn them off in order to make sound investment decisions.
I was reminded of this a few days ago while interviewing the behavioural finance professor and author Meir Statman. I asked him whether, as an investor, he felt the urge to act irrationally himself. The answer, he said, was that of course he does. His own behavioural weak spot, he said, is his tendency to regret investment decisions and to let that influence his thought processes.
Think about that for a moment: if one of the world’s most distinguished experts in behavioural finance struggles with his own investment behaviour, we shouldn’t be surprised that we do too.
So why not start addressing your investment behaviour today? If we all did that, perhaps the financial industry will one day be very much smaller than it is now?
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