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While the whole investment world remains obsessed over the latest trends in the markets, it is important to understand the behavioral aspects of finance which impact the decisions taken by portfolio managers and investors to stay ahead of the curve.
Renowned author Morgan Housel, author of the best-seller ‘The Psychology of Money’ shares his insights on how behavioral biases impact people’s investment decisions and how MFDs can prepare for themselves in a conversation with Prem Khatri, Founder, Cafemutual. Here are the insights shared by the renowned author.
Behavioral challenges in MF investors
The biggest pitfall is of the need to be long-term investors. Investors forget that the long-term is just a collection of short terms. So, if they want to be invested for the next 20 years as investors, they need to put up with all of the short-term volatility and all of the challenges, all of the surprises that are guaranteed to happen.
Morgan says that he is a long-term optimist and believes that in the long run, the world will be a better place 20-30 years from now than the present. However, it is also important to be realistic and understand how hard it's going to be to get there between now and then.
And so, if someone wants to be a long-term investor in mutual funds, he has to compulsorily deal with on an almost daily basis, uncertainty, volatility, greed and fear. The ability to manage that on a daily basis is very important.
How should MFDs deal with behavioral biases?
Morgan shares that it is important for MFDs to realize that every investor has different goals and aspirations. And so, there is not a single right way to manage money.
He believes that no fund manager or financial advisor can say that their way of investment is the right way to invest. There is no one right way to invest as it is going to be different for everybody.
It is important to understand that two people of the same intelligence, the same education, equally informed, can come to very different conclusions about what they do with their money.
Patterns of behavior in MF investors
Morgan shares his experience of dealing with global crisis and explains that the issue which is considered the biggest risk today may be something that affects the market in the short term. However, in the medium to long term, the markets may be affected by something that nobody is talking about today.
The biggest risk is what people do not anticipate. And as no one sees such problems coming, there is no preparation for it, which makes them even more risky. It is only when the global economy is in the middle of the crisis that everyone starts preparing for it.
It is the surprising nature of these events that causes high amount of damage. He explains that this has been the case in the past and will continue to remain in the future.
Importance of patience in successful long-term investment
Morgan says that the best way to understand the role of patience is to understand what does an investor get paid for overtime. He explains that return on investment is the cost of putting up with and dealing with a never-ending parade of uncertainty and volatility.
He adds that investors look at market volatility and correction as a mistake of their financial advisor, portfolio manager, government or the central bank. However, the stock market is volatile because that is the cost of admission. It is only because an investor puts up with the volatility that he generates a return in the long-term. So, investors should have the ability to accept it.
Can MFDs overcome the behavioral biases of their clients?
Morgan explains that investors have a lot of behavioral biases such as recency bias, loss aversion, overconfidence. However, such biases cannot be overcome by reading a book or a blog as it is the natural behavior of human beings.
And so, he asks MFDs to embrace their clients’ biases and have a financial plan that accepts them. For example, if an MFD has a client who panics every time the stock market goes down 20%, rather than trying to fix that, they should just learn from that and ask such clients to not have more than half of their net worth in equity markets.
He shares that although people feel that they can fix their past mistakes, they are more likely to repeat them during the next correction as their mind’s way of dealing with fear, greed and how they think about risk and worst case scenarios will not change. So, it is better to embrace this behavior.
How can MFDs manage foster better decision-making?
Morgan says that whether in the present or the future, a large number of investors will make their financial decisions based on greed and fear.
He advises portfolio managers to use a correction to their advantage and buy a little bit more when markets are down and buy a little bit less when they go up. He thinks that this is the best that portfolio managers can do.
Will everyone become smart investors in the future?
When asked about whether every investor after understanding their biases will become smart investors and lose any advantage over others, Morgan gives the example of how in the past, fundamental analysis used to be rare but is now a common practice in stock selection.
He shares that the masses have always acted against wisdom. A lot of wisdom shared centuries ago is not being followed today. Similarly, behavioral biases are such a normal part of human behavior that despite advancements in knowing them and spreading awareness about them, investor behavior has not improved but has gone worse due to trends like day trading, zero-day trading and crypto investment.
And so, he expects the investment behavior to remain the same in the future. Just as the cycle of new technologies, new markets, new economies, new political structures, different wars and recessions will not change, the investors’ behavior will also never change.
Maintaining a balanced approach to investing
Morgan shares that his writing is just a reflection of his experiences and he is prone to all the biases and behaviors which he writes about.
He shares his investment choices which includes dollar-cost averaging into index funds over long-term. He wishes to stay invested in them for the next 50 years and give most of it away to charity.
He says that he has always been a patient long-term investor. He adds that despite studying behavioral finance, he cannot perfectly implement his learnings in real life. However, he emphasizes the importance of being aware about them.
And due to this, he is able to compartmentalize his greed and fear more.
Advise for MFDs
Morgan advises MFDs and asks them to understand that the future will be better than what they expect but the road to the better future will be hard. He thinks that this perfectly describes the psychology of every investor. A good investor invests as he knows the future is going to be great but an investor who gets scared of the volatility is a bad investor.
That's the path for so many different investors over time and understanding these two paths is probably the most important thing to understand about the psychology of investing.
