How can behavioural finance inform the investment process? We have taken a hypothetical ‘typical’ large fund management house and analysed their process. This collection of notes tries to explore some of the areas in which understanding psychology could radically alter the way they structure their businesses. The results may challenge some of your most deeply held beliefs.
This collection of notes aims to explore some of the more obvious behavioural weaknesses inherent in the ‘average’ investment process.
Seven sins (common mistakes) were identified. The first was placing forecasting at the very heart of the investment process. An enormous amount of evidence suggests that investors are generally hopeless at forecasting. So using forecasts as an integral part of the investment process is like tying one hand behind your back before you start.
Secondly, investors seem to be obsessed with information. Instead of focusing on a few important factors (such as valuations and earnings quality), many investors spend countless hours trying to become experts about almost everything. The evidence suggests that in general more information just makes us increasingly over-confident rather than better at making decisions.
Thirdly, the insistence of spending hours meeting company managements strikes us as bizarre from a psychological standpoint. We aren’t good at looking for information that will prove us to be wrong. So most of the time, these meetings are likely to be mutual loveins. Our ability to spot deception is also very poor, so we won’t even spot who is lying.
Fourthly, many investors spend their time trying to ‘beat the gun’ as Keynes put it. Effectively, everyone thinks they can get in at the bottom and out at the top. However,this seems to be remarkably hubristic.
Fifthly, many investors seem to end up trying to perform on very short time horizons and over trade as a consequence. The average holding period for a stock on the NYSE is 11months! This has nothing to do with investment, it is speculation, pure and simple.