Alan’s Blog June 2012

Newsletter & Alan’s Blog June 2012

The News

During the last month business meetings have kept me busy as usual: ‘The Adviser Gym’ with David Scarlett in Manchester; ‘Life Planning Mastery’ seminar with George Kinder in London; ‘Prestwood’ business workshop with Simon Williamson in Droitwich to mention a few. So many workshops are now ‘virtual’ and conducted on line which saves time and travel. My own screen sharing facility which has been running for several months has received very positive feedback, one client saying recently: “Wonderful we’ve done everything that we would have done if I had visited your office”.

What has shocked me over the last month was the publication of surveys which showed that huge numbers of IFA businesses are not ready for the implementation of the RDR on 1st January (just over 6 months away). I’ve arranged meetings and workshops with the FSA on 5th and 18th July to confirm that all is in order and so that I can just dot the ‘i’s and cross the ‘t’s.

More administrative support from ‘Time-etc’ has just been engaged and we are developing systems and processes with Michelle Hoskin of The Adviser Partnership starting with a full day meeting on 2nd July. Business efficiency and Client service is top of the agenda and you will hear more about this as it develops.

This month my continuing discussion of the “The 7 Secrets of Money” is about investment behaviour: ‘The 7 Secrets of Money’ is a book that I strongly recommend: you can get your own copy from Amazon and for more information you could look at the authors’ website at www.7secretsofmoney.co.uk.

Secret Number 6: “Your behaviour will define your return”

“95% of wealth creation comes from your behaviour and 5% from your investments”

We like to think of ourselves as rational beings but this is no so when it comes to investing. We are programmed to respond emotionally and not rationally: we are just not wired for prudent, long term investing. Issues around finance appeal to our base emotions of fear and greed. This leads us to damaging behaviour such as taking too much risk in the hope that we hit that elusive jackpot.

With knowledge and discipline we can all learn to control our instincts for a better investment outcome. No plan is going to survive the vicissitudes of life without a real understanding of how you relate to money. When things start to go wrong, and go wrong they will, it is important that you understand how you are hard-wired to act and take that understanding into account before you act.

Acquiring this knowledge and discipline is difficult to do unaided and you should seek the assistance of an experienced financial guide to help you control your natural inclinations and achieve your goals.

It is worth emphasising this point again and research shown by behaviourists show that many stock market investors act far from rationally. When faced with risky decisions often our ‘emotion overwhelms reason’: our behavioural biases can trump rational thought. Recent research has shown that ‘financial losses are processed in the same areas of the brain that respond to mortal danger’.

Six examples of behavioural bias

Behavioural bias 1 – inertia and regret avoidance

‘It’s too complicated’; I don’t know who to trust’; ‘I will be alright as I am’; ‘what if it all goes wrong’; ‘I don’t know where to start’; ‘I have no time to plan for the future, I live for today’

This is one of the most damaging behaviour and has the potential to stop a person investing at all and not engaging in any financial planning.

Behavioural bias 2 – slave to fashion (or ‘herding’)

Do you get your investment tips from friends and family or at the golf club?

There is comfort in being part of a group but conventional wisdom is usually wrong. If everyone believes that particular stocks are the best investment that usually means that because everyone has bought them, demand and therefore prices are high and future expected returns are low.

If the herd moves in one direction it might be time to consider moving the other way.

Behavioural bias 3 – overconfidence

Researchers in cognitive psychology have shown that we all tend to be overconfident about our beliefs and abilities and over optimistic about assessments of the future.

Most investors believe that they can beat the market and they tend to speculate too much and trade too much, incurring every–increasing costs. This is the foundation of the active management industry and leads investors to buy high and sell low, with the result that the average investor experience below market returns.

Behavioural bias 4 – hindsight bias

Another psychological finding called ‘hindsight bias’ refers to our tendency to see events that have already occurred as more predictable than before they took place. Hindsight promotes the illusion that the future is far more predictable than it is.

Investors often make the assumption that the immediate past is predictive of the long-term future and it responsible for making investors buy stocks when prices are going up and stops them buying stocks or even selling them when prices have been going down.

In good times people are often willing to take risks whereas in bad times they are afraid of taking risks. However by the nature of the market risk premiums (expected future returns) increase in bad times and the opposite is true in bad times.

To emphasise this point: Future expected returns on equities are lower when economic conditions are strong and higher when economic conditions are weak.

This contradicts most investors’ preference to ‘buy high and sell low’. A sensible rebalancing strategy provides the on-going discipline necessary to do the opposite: i.e. to sell high and buy low.

Behavioural bias 5 – the self-attribution bias

Our ‘self-attribution bias’ means that we tend to want to take full credit for success, but blame failures on outside influence.

On average we are all average – and make an average number of smart decisions and mistakes. Individually, however, we think that we all think we were ‘smart’ when things work in our favour and ‘unlucky’ when thing work against us.

Behavioural bias 6 – where is the excitement?

Indexing and passive investment work extremely well but for many investors it is dull and boring. People regularly exchange large amounts of money for excitement – gambling is a very common activity even though most people know that on average they will end up with less than they started with. Why bet on the outsider instead of the favourite? Why by a lottery ticket when we know that the jackpot chance is 1 in 13,983,816 or approximately 1 in 14 million?

Do not confuse long-term investing with short-term speculating. Speculate with money you can afford to lose, invest with money for which it is essential to retain purchasing power.

Studies of investor behaviour show that investors are either systematically bad gamblers, or they are succumbing to the behavioural biases that lead to poor investment decision making. Or a combination of both!

We are naturally attracted to the sweet and fatty foods but what we need is a balanced meal which is not always so exciting, filling or immediately gratifying.

How can we control our natural biases?

1                     Recognise the biases that we are prone to: Take a good hard look at your own personal attitudes and behaviours around money. Most approaches to managing your money jump in at the ‘planning what you need to do’ stage. We know from experience that unless you do the exploration first your chances of achieving success subsequently are slim. First understand the drivers and how to react to them; then you will be in a position to make money work for you and do the job it was designed to do.

•     To quote Adam Smith:” If you don’t know who you really are the stock market is an expensive place to find out”

2                     The second part of the answer is to implement the right type of investment strategy, recognising what you can control and what you can’t. [More of this secret number 7 next month]

3                     The third part is to keep the discipline of the investment strategy and not to be fooled by the media or friends into thinking that you or anyone you are likely to meet can predict the future.

Understanding your personal inclinations will allow you to being to properly identify those things which you cannot control but it is very difficult to accomplish this on your own. Finding the right financial guide to assist you in developing and sticking to a proper financial plan is a vital contributor to success.

“At the end of our investing lifetime, it won’t matter what your funds did, it will matter what you did. And what you did will be a pure function of the quality for the advice you got – from one caring, competent adviser and not from any number of magazines” – Nick Murray

Understanding your behavioural biases is one of the hardest and most rewarding things for you to do. If you can do this successfully, you will be relieved to hear that investment is actually a simple process. In secret number 7 next month we explain how to give you clarity as you build your portfolio and start on your journey to a financial peace of mind.