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Standard Life: Five ways to make yourself a better investor | Trustnet Skip to the content

Standard Life: Five ways to make yourself a better investor

13 September 2013

Strategist Frances Hudson reveals some of the techniques used by the group that retail investors can also use to their advantage.

By Thomas McMahon,

Senior Reporter, FE Trustnet

Standard Life has published some of the advanced techniques it uses to make better investment decisions, drawing on the latest research into behavioural science and the use of computers.

The asset manager tries to blend the advantages of human decision-makers and machines into a superior process that avoids the shortcomings of both, according to Frances Hudson (pictured), global thematic strategist at the group.

ALT_TAG Many of the strategies it implements through computers and the algorithms it runs on them, but a number of key strategies are adaptable to retail investors managing their own money.

Here are some of the key points it raised.


Think about scenarios

Hudson suggests that investors can protect themselves by war-gaming future negative scenarios.

"Rather than predicating the future on single analogies or past correlations, in which circumstance and context can have played a large part, a range of outcomes can be considered, using, say, conditional probabilities."

Standard Life finds this to be particularly useful to avoid the kind of group-think that can enter into decisions taken by committee.

It may seem that getting different views is enough to improve decisions, but committees have dynamics which can disrupt this.

"Setting up a workable scenario process entails circumnavigating the pitfalls of committees and progressing towards better collective decisions," Hudson said.

However, it is also helpful on an individual level to begin to start avoiding the cognitive biases that afflict human beings.

"The rationale for discussing what could go wrong is not an exercise in appeasing the pessimists," she added.

"Two major benefits lie in increased tolerance for occasions when events, inevitably, deviate from expected outcomes and, secondly, the discussion can provide an opportunity and prompt to take pre-emptive action if required. This promotes a more robust approach."

It can be hard to think outside the set of assumptions of those around you, which is proved by the behaviour of markets as much as by individuals, Hudson says.

"Markets can be subject to the same behavioural foibles as individuals, compounded by herding tendencies where, rather than cancelling each other out, individual biases combine and escalate into extremes or bubbles."

"Overshooting is a common feature in some markets, suggesting that insider views are prevalent."

Standard Life can apply this approach through computing power, although this option is denied to the average private investor.

"The assessment stages of our process draw on past periods which have similar characteristics, albeit using them for information rather than as quantitative templates."

"Rather than solely relying on historic correlations, Monte Carlo simulations employ computational algorithms to model possible outcomes."


Be contrarian

It is particularly important to think through unpopular scenarios, as this will help individuals and groups think outside their own assumptions, Hudson continued.

"The contrarian thought process required in coming up with plausible rather than probable extreme scenarios that could upset the existing portfolio is designed to move beyond the 'insider' view at the outset," she said.


Consider fat tails

Investors need to pay special attention to extreme events, which occur far more frequently than people expect.

This is what is meant by the term "fat tails", which refers to the probability distribution of certain measures.

A distribution with "fat tails" will see more extreme events than in the normal distribution and possibly more than investors expect.

"Investors often do not realise how unpredictable a complex world can be, one where exogenous shocks can knock a finely crafted forecast off track," Hudson said.

"In addition, it is human nature not to think about extreme events, or realise that their probability can be relatively high, as any statistical analysis of fat-tail events can show."


Beware confirmation bias

"A significant part of behavioural finance is concerned with flaws in decision making. A tendency to ascribe heavier weights to more recent information is one pitfall," Hudson said.

"We anchor or frame our views using a central belief as a reference point, which may not be the appropriate starting point."

"Then confirmation bias means that we interpret ambiguous information in a way that favours the views that are already held."

In short, investors tend to concentrate on information that suggests they are right and explain away that which suggests they are wrong.


Do not always try to be right


Hudson warns that sometimes it can be dangerous to stick to your guns, even if you are right.

The saying attributed to Keynes that "the markets can be irrational longer than you or I can be solvent" raises the pertinent issue: sometimes it is wise to go with the flow or step out of the market if it seems to be against you.

"Irrespective of whether the market is wise or foolish, betting against it can be costly," Hudson said. "History is well-populated with investors who mistakenly thought they could take on the markets and win, either on an individual or corporate basis."

"Hedge funds and proprietary trading desks have had some spectacular failures and losses, with Long Term Capital Management, Amaranth Advisors and Tiger Funds among the high-profile casualties."

"Barings in the past and Societe Generale, UBS and JP Morgan more recently have also suffered substantial reversals which started with traders misreading the markets and compounding their errors through behavioural biases."
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