Behavioural bias and fees when managing capital

Anyone that runs their own portfolio will have heard the saying “bear markets turn traders into long term investors”. Outside of the obviously facetious element of the quote, it raises an interesting point about loss aversion – mainly that many retail investors seek to avoid crystallising losses in the hope of a share price rebound far longer than is sensible. This behaviour is an example of a behavioural bias, a behaviour based on cognitive errors and emotional responses. We all suffer from different forms of behavioural bias but the shrewd investor works to identify and minimise their impact over time.

Many, if not most, retail investors overestimate their capabilities when it comes to analysing markets and investments. Although I don’t believe that the process of managing your own investments is fundamentally beyond most people, it does take more work than reading a few tip sheets once a month to do it responsibly. When discussing the topic with fellow investors, I’m often struck by how few times investors really consider the potential for being wrong about a decision – or at least, how few times that potential outcome is presented to me as a possibility.

This overconfidence often leads retail investors to undertake ill-advised attempts at market timing or overconcentration into risky investments thanks to different types of behavioural bias. In short, behavioural bias is a systematic, predicatable error than an investor makes when they interpret and act on information.

For example, emotions influence investors – when markets are buoyant, we want to buy, and when markets are bearish, we want to sell. The mood of the investor should play no part in the management of the portfolio but evidence shows that investors often become more optimistic and self-confident when markets rise but suffer from outsized fear-type reactions when markets fall.

These emotional swings increase the mental pressure on an investor to take action during times of peak market momentum – usually based on nothing more concrete than feelings. Understanding your own emotional state and managing it is absolutely essential for effective, long-term investing, and whether it’s fear, greed or euphoria, investors should make their decisions based on facts rather than emotions.

Coming back to the idea of loss aversion, studies have shown that the majority of investors have an asymmetrical fear of loss over pleasure at reward. If an investment makes £10,000 in a year, the typical investor is pleased with the return, but if the same investment LOSES £10,000 they’re absolutely devastated. As a result of this, many investors will ‘hang onto’ poorly performing investments in the hope of them eventually turning good, long past the point when they should have let go.

A significant part of my own investing strategy is therefore working to identify, minimise and mitigate the impact of these different types of behavioural bias on my investment returns. Ten years ago, my managed portfolio was primarily invested in the UK but today it includes weightings to the US, Europe and Asia. Ten years ago, my portfolio was 95% invested in individual equities with less than 1% allocated to cash but today it has a 30% weighting to non-UK equities and a 10% weighting to cash & cash equivalents. These changes are an active result of me attempting to mitigate against being wrong – both about the potential for the UK economy and about individual companies within it. Despite this, behavioral biases remain an entrenched risk for me as a retail investor, and I would suggest remain an entrenched risk for most others.

By comparison, professional money managers have an advantage in that they are trained to understand the impact of behavioral biases and therefore attempt to mitigate their impact on returns. Professional money managers are often considered the ‘smart money’ (I’ll leave readers to consider what that makes the rest of us). This presentation has given rise to an incredible complex and sophisticated network of wealth managers and advisors, some of whom have approached me over the years to gain me as a client and manage my capital. The pitch usually goes as follows;

  • We all know that capital left in cash loses money to inflation over time. Some level of investment in productive assets is required to outrun inflation and avoid an inevitable loss of purchasing power. This is bad.
  • By hiring a full-time financial professional, I would benefit from their many years of experience in the industry and their training in a variety of specialist techniques to ensure capital is invested to grow over time and protect my purchasing power. This would be good.
  • By contrast, I am obviously not a full-time financial specialist. I have no training, no tools, no background, and although I am an intelligent, articulate individual, it makes about as much sense for me to undertake this specialist work as it does for me to attempt brain surgery.
  • As I wouldn’t attempt to carry out brain surgery with no training, why would I attempt to manage this similarly complex set of procedures on my own?
  • If I hand over my capital to this individual and their firm, I will benefit from the very best specialists that money can buy and access:
    • Highly trained, full-time market analysts to undertake valuation and asset research.
    • Overseas and specialist investment products used by some of the most famous and ‘high net worth’ investors of all time
    • Preferential rates thanks to the economies of scale negotiated by the firm managing such significant volumes of capital
    • Tax planning specialists for complex situations such as long-term family planning, international and multi-jurisdictional asset structures
    • Bespoke advice on how to achieve your long-term objectives and goals. Particularly useful for avoiding those pesky behavioral biases
  • All of this could be mine for just a few percentage points a year. This is really very modest for the breadth of specialist information and platform tools that will be made available to me. After all, would I really quibble at paying 2 or 3% of your funds a year to know that they’re in hands of the best trained specialists in the market?

Although on the face of it, this seems like a fairly compelling argument, there\’s one important catch. The fees, although usually described as \’just\’ a few percentage points a year, run the risk of seriously damaging your wealth over time. On a £100,000 of assets, every 1% of fees is costing you £1,000 a year. On a pot worth £500,000, you’d pay an additional £200,000 in fees over 40 years by paying 2% instead of 1%. It’s not uncommon for fees to add up to 3 or 4% in total – between the management fee, fund fees, platform fees and dealing fees, you could be losing hundreds of thousands of pounds in fees over your working career by paying more than you need to.

Reducing those fees would provide a significant tailwind to your portfolio and overall returns. This is hugely significant and represents a truly extraordinary \’run rate\’ that professional money managers have to meet just to stand still. By comparison, as an individual investor, the \’cost\’ you face tends to be mostly time-based, providing you can keep a handle on issues such as behavioral biases. Unlike the professional money manager, part of your returns are being siphoned off to pay someone else\’s salary. To make 10% a year, the manager charging 3% fees actually needs to generate 13% in returns, making it easier for you to at least \’keep pace\’ with the professionals providing your strategy is effective.

Having said this, an individual investor could also lose hundreds of thousands by failing to manage their risk, undertaking poor market timing, making decisions based on emotions rather than facts, or perhaps just sheer bad luck. Managing your own money might be cheaper, but it doesn\’t automatically mean it’s better. My solution, therefore, has been to take an active interest in managing by own money, but with a contingent focus on limiting the impact of biases on performance and constantly working to refine and improve my approach. To do this, I ask myself a few questions about my investing strategy:

  1. What are the main reasons I want to invest or divest from a particular asset? Is this a long-term investment, a short-term speculative opportunity, am I responding to market noise or informed macroeconomic analysis?
  2. What evidence have I considered to support my decision?
  3. Have I encountered any evidence that points to me being incorrect and if so what have I done to validate/invalidate it?
  4. What will the impact of being wrong be? Even if I believe I have validated my thesis, if I am still wrong, or just unlucky, what will the impact on my overall returns be?
  5. What alternatives have I considered to a course of action?

By asking these questions (and answering them), I’m attempting to drive down both the risk and impact of being incorrect about a particular investment decision, and guard against \’Manager Risk\’ i.e the risk of me doing the wrong thing. I\’m constantly looking for examples of my own behavioural bias and working to eliminate them.

For example, when I was younger, I quickly learned that my propensity to spend money was practically unlimited. No matter how much I earned, I could always find new things I wanted – I could spend every penny I had and manage to save absolutely nothing. Even though fundamentally, I knew that saving money was a good thing, my self-discipline was insufficient to ensure it, and so I was saving too little and spending too much. As a result, I quickly took the decision away from myself in the form of a regular saver – £x a month was automatically stashed in a savings account which I couldn’t access for twelve months. At the end of the year, I hadn’t really ‘missed’ the money and now had a nice pot of savings to boot, eliminating the impact of the behavioural bias for spending over saving.

My lesson was that there were going to be occasions when my own discipline and self-control would be insufficient to ensure I made the right decision and that therefore there were some circumstances where removing my ability to ‘self-sabotage’ would be critical to my success. Different industries have different terms for this but broadly speaking it can be summarised as ‘know when to delegate’.

When it comes to my investments, this ‘delegation’ takes two forms. Firstly, I recognise that the odds of being able to outperform are slim but that one strategy to improve my odds is to focus. Rather than attempt to become an expert on every market, sector and geography, I constrain my stock picking activities primarily to the UK, which is my home market. To avoid against the risk of the UK underperforming other markets, I also buy exposure to foreign markets, but primarily use a combination of passive index and actively managed funds to gain exposure to diversify my holdings.

To guard against the risk of this strategy underperforming, I also spread my net worth across multiple asset types – some professionally managed funds, some self-managed – including equities, commodities, property, cash, and private market investments. In the event that an asset, manager, or individual strategy, underperforms, this reduces the impact – diluting total returns but reducing risk along with it. My assumption isn\’t that I will automatically make the right decision when investing, or even that if I make the right decision that I will get to the right outcome, but that I need to guard to against the damage caused when I make the wrong decision or fail to get the right outcome. Over time, my is that this approach will balances risk, reward, fees and financial outcomes by minimising the impact of behavioural bias.

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