As behavioural economists remind us, investors often act irrationally - particularly when markets are rising or falling sharply. And their common behavioural biases can become significant barriers to investment success.
Several of the undesirable biases identified by behavioural economists over the past 25 years or so are worth thinking about during the prevailing sharemarket volatility. These include what is known as "narrow framing".
Narrow framing is the tendency for investors to concentrate much of their attention on a single aspect of their overall investment portfolios. In turn, this may result in overreacting to short-term falls in share prices in the context of current market volatility.
The Journal of Portfolio Management in the US recently published a timely article, Bad habits and good practices, emphasising that investors falling into trap of narrow framing tend not to fully appreciate the benefits of portfolio diversification.
"It is easier to delve into one attention-grabbing investment than into its interactions with the rest of the portfolio," write the article's authors, Amit Goyal, a professor at the University of Lausanne, and Anitti Ilmanen, a London investment funds manager.
"Fortunately," Goyal and Ilmanen add, "each bad habit has a flip side: a good investment practice". They explain that good practice involves investing in a "consistent, disciplined and patient manner" following a strategic, long-term strategy.
Five years ago, Vanguard published a research paper - headed Understanding how the mind can help or hinder investment success - to provide a succinct explanation of behavioural finance including the investor bias of narrow framing.
Investors taking a narrow frame, the Vanguard paper explains, have a tendency to "fret over the performance" of a single investment or investment sector, increasing their sensitivity to loss.
Investors taking what could be described as a wider frame would tend to see a fall in the price of individual investments or an asset sector as just part of the expected movements within an appropriately-diversified portfolio. Indeed, diversified portfolios are specifically designed with the intention of having some assets rising in value to counter other assets falling in value.
In summary, investors determined to try to avoid the traps identified by behavioural economists typically:
- Set clear and appropriate investment goals.
- Develop a suitable long-term asset allocation for their portfolios, taking into account their goals, tolerance to risk and the need to diversify their risks and rewards.
- Remain committed to their appropriate long-term investment strategy through periods of market uncertainty and increased volatility.
Behavioural economists say investors should recognise that they are vulnerable to making irrational decisions and take such steps to keep undesirable behavioural biases in check.
By Robin Bowerman
Principal & Head of Retail, Vanguard Investments Australia
13 August 2015