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All Investors Behave Rationally, Right?

For many years, investment advisers and financial planners followed the ideas promulgated by Harry Markowitz in his Modern Portfolio Theory (MPT) approach which provided investors with a formal risk/return framework for making decisions aimed at maximising portfolio returns.

The assumption is that investors armed with all the necessary information will take the rational, logical, and efficient pathway to maximise returns - and will do so in a timely fashion that enhances portfolio performance.

In various papers, Daniel Kahneman and Amos Tversky challenged this idea of investor rationality with their theory of behavioural finance. In essence, this approach stated that investors, far from behaving rationally, are prone to emotional and irrational behaviour based on deeply internalised attitudes to matters financial which work against portfolio optimisation.behaviour.

Their ideas were progressed further by Richard Thaler and others more convinced that client behaviour impacts portfolio returns than any other single factor.

Anecdotally, many financial advisers will confirm the irrationality of clients and the errant, often panicky reactions to micro and macro events that influence their thinking and cause inappropriate behaviour.

Nick Murray in 'Behavior Investment Counseling' addresses the issue of clients trying to 'beat the market' by citing the DALBAR, Inc longitudinal study showing that the average return of all large cap US Equity Funds exceeds the average return achieved by all investors in the same funds by a considerable margin. Investors seeking to time their entry and exit to/from these funds based on their assessment of the crisis of the day, only serves to defeat the investor's objectives.

"Over 20 year periods, the average fund investor consistently manages to capture much less than half of the return of the average fund".

So the average investor in attempting to beat his/her own investments creates the opposite outcome, by buying the most recent 'hot performer', constantly switching when these previous high performers fall from grace, move to a predominantly cash position after equity indices dip, or otherwise trying to time entry and exit.

As Murray so succinctly puts it -

"Thats' the tragedy, in a nutshell: presented again and again with irrefutable evidence that the central problem is emotional/behavioural - that is housed in the investor's emotions - advisers seek ever more complex intellectual/analytical remedies on the bizarre assumption that the problem is housed in the intellect"

So advisers are faced with matters much less technical than analysing charts, graphs, or possible market trends - but with human behaviour.

How much time was allotted to this knotty issue of dealing with human behaviour in your CFP course, your pathway to AFA status, or other formal financial planning qualification hanging on your office wall?

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