Keep it simple to ride out market emotions

There is one clear lesson investors can learn from the recent sharemarket turmoil - the smart way to invest is to keep things simple. 

 

Overconfidence is a real trap that investors can unwittingly fall into for no other reason than as human beings we are wired to behave that way. 

 

Not that overconfidence is restricted to individuals or the field of investing. How do you rate yourself as a driver? 

 

Researchers typically find that 80% of car drivers rate themselves "above average" when asked. 

 

The study of behavioural finance is a relatively new area of academic research that combines psychology and economics to try and explain why, as investors, we behave sometimes in ways that fails basic tests of rational logic. 

 

Steve Utkus, the head of Vanguard's US Centre for Retirement Research, has worked in this field of research for many years and has been in Australia this month speaking about how the behavioural studies can help us dodge some of our basic emotional responses that can trip us up along the investing journey. 

 

He believes that after a long and strong growth market it is no surprise that overconfidence crept into the investing landscape. But why are we overconfident? For a start most of us are not good statisticians and typically look to create order out of random chaos. That has been well illustrated in a range of tests involving the simple tossing of a coin. 

 

Each time you toss a coin it is a random event - unrelated to the prior toss or the next one. Yet if people are shown the results of a series of coin tosses - for example a coin tossed five times with four heads and one tail - what would you think the next toss is likely to be? 

 

This overconfidence in our ability to predict future outcomes from past patterns is clearly a major risk in investing - and no amount of mandatory warnings about past performance not being a guide to future performance is likely to change that.

 

Another area of risk, according to Utkus, is becoming overconfident about our ability to personally control portfolio outcomes - that is people believing that they have been responsible for their portfolio's strong returns. 

 

This flys in the face of numerous research studies that show market forces are much more important in determining a portfolio's performance and volatility - in fact probably contribute about 80% of the return. If the recent market shocks teach us anything it is that market forces are both powerful and almost impossible to predict. Some analysts were warning of the US sub-prime mortgage situation a year out but no-one could have predicted the contagion effect on liquidity and subsequent impacts on market valuations. 

 

Self-directed investors, Utkus says, fall into the trap of believing they have much more control than they do in reality. That can lead to excessive trading and a tendency to remember the winners and downplay the losers. 

 

Clearly this is not just a problem for individual investors - fund managers are certainly not immune to overconfidence, nor are financial advisers and the consumer finance media. The media is particularly interesting because it can move from confidently listing the 10 top growth stocks in a bull market to proclaiming the 10 best bargain buys after the market has nosedived. 

 

Utkus reminds us that it is worth remembering that when people declare "they are 100% sure" of something they are wrong 20% of the time. 

 

So how do you guard against overconfidence? 

 

Some straightforward strategies revolve around seeking external validation, using independent information and looking at dispassionate performance measures. 

 

Focussing on the broadest frame of reference - such as putting the recent sharemarket losses in the context of your overall wealth including super, your house, even your income helps people see short-term events in a longer-term context. 

 

But it also comes back to the notion of keeping things simple. If you do not understand how something works how can you be sure you understand the risks? 

 

It is a question that some overconfident yet highly qualified investment bankers are struggling to answer around the world.