Cover story – The psychology of investing
Putting intellectual meat on the bones of this, Paul Craven, a behavioural economist, says: “There is a form of economic thinking that says we are all rational, logical, analytical, data- driven and evidence-based. What behavioural science suggests is that we make decisions for lots of other reasons. We make mental short cuts, what is known by psychologists as heuris- tics. I like to think of them as having biases.” And such biases in investment are key. “When everyone starts to think the same way, it is dangerous. In investment terms, therefore, the biases we have are important,” Craven says. He cites an example: “The bandwagon effect in investment, or the herd instinct, is the idea you choose to follow what everyone else is doing because they must know something you don’t, or something better. “And there is strength in numbers. And if I am wrong, I am not going to stand out. Interestingly, in markets this can lead to financial market bubbles,” he adds. Furthermore, not only do they lead to bubbles but the herd instinct repeats itself, as the history of the stock market shows. There is another bias Craven identifies: “Hindsight bias is something we are all guilty of: we are all experts with hindsight.”
Market psychology
Professor Richard Thaler of the University of Chicago School of Business and the economist behind the ‘nudge’ theory has also studied markets and market behaviour. He has a more sceptical view of the psychology of markets per- spective. “When people talk about ‘market psychology’ they are often referring to just the unpredictable turns in market sentiment,” he says.
“It is a mistake,” Thaler adds, “to think that such factors are irrelevant, but it is also a mistake to think that you can make money trying to predict when they will change. So-called meme stocks remained high for much longer than most people expected, and short sellers were either wiped out or lost patience.
“My view is that stock prices can deviate from fundamentals – somehow defined – for long periods of time, and yet that may not create an opportunity to make a profit,” he says. But not all investment problems are down to psychological highs and lows reflected in the market but can be down to something close to the psychology of hubris, Marks says. “Most investors cannot see the future better than anyone else. And trying to predict the future will not produce investment success.
The most important thing they do not teach you in business school is psychology.
Howard Marks, author
“One of my heroes [the economist] JK Galbraith said: ‘We have two types of forecasters: one who don’t know, and the ones that don’t know they don’t know.’” This a tad Donald Rumsfeld, in his famous known unknowns speech, but it does raise a serious point about the psychology of investing. One in which in plugging into, and exploiting, future investment trends is open to question. “The truth is, the future is uncertain,” Marks adds. “And yet, what is investing, but employing money for the future. Most investors act as if they can see the future and they base their investment decisions on their view of the future. It is danger- ous, because if it turns out they cannot, as I believe, then there is a problem.” Supporting his perspective, Marks cites a conversation he once had with a famous friend. “Warren Buffet said to me once, ‘For a piece of information to be desirable, it has to satisfy two cri- teria: it has to be important and it has to be knowable.’ “The macro is extremely important: how can you not base your approach on macro? I say yes, but it is not knowable. Then bas- ing your approach on macro is a waste of time, or worse,” Marks adds.
This is wandering into territory that questions some of the essence of investment, but it does have its foundation in a par- ticular psychology of investing. It also highlights something else. Euan Munro, chief executive of Newton Investment Man- agement, warns that there needs to be a line created between speculation – which this could be viewed as – and investment. “I have seen a comment from a crypto expert opining that it was a good thing that the froth is coming out of the crypto mar- ket. Perhaps he needs to be careful what he wishes for,” he says. “To my mind, froth in a market is when over ambitious growth expectation for a company’s profits might need to be revised down,” Munro adds. “This results in a change in valuation, but the substance of the investment is still there. I am seriously
20 | portfolio institutional | July–August 2022 | issue 115
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