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Check your biases before you invest or you are likely to lose money

07 December 2022

Psychological biases can get in the way of true diversification.

By Matteo Anelli,

Reporter, Trustnet

The mind is a trickster, and good investors should be able to recognise their own flaws and not fall into costly traps, according to Greg Davies, head of behavioural finance at the behavioural fintech Oxford Risk.

Speaking to Aviva Investors, he said savers might be unaware of psychological obstacles that could interfere with the construction of a well-diversified portfolio.

Investors are subject to the same human prejudices as everybody else, but, if not identified, these inbuilt prejudices could expose their portfolios to the same kind of risks throughout multiple assets, leading to a greater probability of hefty losses.

The risk is to end up with “a highly concentrated portfolio of good stories”, rather than a diversified portfolio providing balance.

“They might have 20% of their wealth in a particular stock because a friend works there and says it is a great company. Or they own a mobile phone, like the product and tell themselves the company must be a good investment”, said Davies.

David Jane, multi-asset manager at Premier Miton, told Trustnet recently that alternatives is an area investors may be falling into this trap.

He took aim at everything from private equity to student housing and aircraft leasing, saying they all came down to three things: companies, loans or real assets.

“All these examples are not really alternatives, in that they all hold the same things, just cut and pasted in a different way. It's a marketing story, rather than the reality,” he said.

Another problem is the so-called confirmation bias, or the tendency to only consider the evidence that reinforces our beliefs and subconsciously discard those against them.

“So, if an investor decides that an investment is a good one, they are likely to look for evidence to support that view, filtering out evidence that would prove them wrong.”

“We like to think that we make up our minds by looking at the evidence and coming to a rational conclusion. But psychological research has shown that, much of the time, the opposite is true. We decide what we want to believe and go looking for the evidence to corroborate that view,” explained Davies.

Ruairi Dennehy, co-head of investment research at Dennehy Weller & Co, said earlier this year that although it is nice to hear people with the same market views, it is easy to fall victim to confirmation bias.

“We regularly keep up to date with what the ‘other crowd’ are saying, as this is just as important for us to understand and evaluate,” he said.

Taking what Jane said above as an example, Anthony Tutrone, global head of alternatives at Neuberger Berman, told Trustnet that alternatives did work, noting that a 60/40 strategy employed by many no longer be optimal.

“Alternatives can also provide diversification while generating compelling risk-adjusted returns. As an inflation hedge, both private equity (PE) and private credit (PC) can offer welcome protection,” he said.

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