The psychology of investing – Cover story


worried that a generation will be badly burned speculating and will subsequently reject investing.”


It’s all in the mind


Another way of looking at this is in what perspective is invest- ment not psychological. A point made by Madeleine King, co- head of global investment grade research at Legal & General Investment Management. “Everything in investment is driven by a certain amount of psychology,” King says. “We are not a completely algorithm-driven market yet. There are a lot of human decisions being made and there are certain human biases there. If you look at things like crypto and some of the market bubbles of late, it is difficult to think of that without thinking of investor psychology. There are few things through- out history that you would look at as an asset bubble, but say, ‘at the time it was driven by fundamentals’. It is rare that hap- pens. It is usually inflated expectations and driven by the fear of missing out, as it is of people genuinely believing this is the next big thing.” Financial bubbles can, therefore, be nothing more than mass psychological hysteria. “There are examples during financial bubbles that markets get driven up, not so much by fundamen- tals but by sentiment, emotion and greed,” Craven says. “Perhaps the tech bubble of the 1990s is a good example where mostly everything that was tech based went up in price and cre- ated a bubble. And even though at the time people said these valuations were justified, up went the prices.” Craven says his favourite example of this mania is Norris Com- munications which used to make electronic recording devices. “It didn’t enjoy the first wave of the tech bubble, or indeed the second wave. In 1999, the last year of the bubble, it changed its name to E Digital – and from a name change its stock price started to rise. It went from 6cents to a peak of $24. And noth- ing had really changed, apart from its name, which reminded people it was a tech company. It’s not trading today.” One way to avoid all this is for investors to be aware of their biases. “Just being aware of our biases is extremely helpful, it takes the sting out of the tail,” Craven says.


Identify stocks


There can be opportunities in considering the psychological aspect of investment. Professor Thaler’s expertise has meant he has put his money where his brain is, exploiting the psy- chology of investment in a specific way. “At the firm I helped found, Fuller & Thaler Asset Management in San Mateo, we use behavioural finance to invest primarily in small and mid-cap US equities. We try to identify stocks for which investors and analysts have biased expectations. We invest in small cap because we think that part of the market is less efficient,” he says.


When everyone starts to think the same way, it is dangerous.


Paul Craven, behavioural economist


Though some market psychology investment approaches do present some bizarre ideas. One is that putting a focus on a winning mentality at all times in all circumstances will ensure investors beat the market. That would be no use in the current environment.


This presents a serious challenge to the broader psychology of investment approach within the current dire macro-economic outlook, with challenges on numerous fronts: rising inflation and the strong prospect of a recession are clearly not all in the mind.


These challenges are as real as they come. And they are the fundamentals. They may have been measured or assessed incorrectly, but, ultimately, the fundamentals have done their job. So what can we make of markets and psychology in this cur- rent context? Thaler says: “Times like this, with high volatility and lots of uncertainty can, in principle, be good times to be disciplined investors with active strategies. If you have a sound investing process, these are ideal times. Certainly, stocks and bonds are cheaper than they were at the beginning of the year, so it is a good time to be investing.”


This is, therefore, stepping into a traditional strategy approach: of having a suitable investment that works.


What advice could the likes of Professor Thaler give institu- tional investors when addressing the psychology of it all? “Have a strategy that appears to work over long periods of time and then attract clients that have patience. Investors, retail and institutional, often fire managers just as their returns are about to go up,” he says.


That could well be read as a wide-ranging warning: be aware of the psychology of investment, but do not ignore the fundamen- tals and certainly do not forget about the wider strategy of investment.


Issue 115 | July–August 2022 | portfolio institutional | 21


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