Humans have evolved with the ability to make quick decisions based on limited stimuli or information. We are often required to act immediately to a potential threat – for example, we press the brakes of a car almost concurrently as an obstacle appears suddenly in the way. Whilst this quick decision-making has always been vital for our survival, the psychology behind it can lead humans to make poor decisions, particularly when the stimuli present is not in the form of a huge bear, an obstacle in front of our car, or other such clear danger. Investment data is a cacophony of complex information, yet we are naturally inclined to respond to this stimulus in a similar way.
Traditional finance theory assumes investors are rational and make optimal decisions 100% of the time. This is clearly not the case. More recently, the field of Behavioural Finance has attempted to understand how investors really make decisions both individually and collectively and how their inherit biases affect their decision making.
COVID-19 has caused extreme market volatility, exacerbated by behaviour biases; fear, the media, and even working at home will have impacted investors thinking. Such behaviour biases include:
- Availability bias: investors make decisions based on the information that comes most easily to their mind, such as the news.
- Representativeness bias: investors classify new information based on past experiences such as the market declines during the global financial crisis in 2008/09.
- Herding bias: many investors make the same decisions at the same time which causes contagion of thought, as well as rapid declines in asset values which cause them to become over/undervalued.
Just as individual investors are susceptible to such behaviour biases, so are professional investment fund managers. One of the ways investors can be confident that their fund managers are able to overcome their biases is by having a robust investment process in place. A manager’s investment process provides an instruction manual on how to manage their fund. Often it can be difficult for investors to determine if managers are following their investment process, however, performance beyond expectations can be an indication they are not following their process and further investigation is required. If a manager has not followed their set process it makes it hard to predict what the future return and risk profile will be.
Trustees will need to work with their advisors to ensure their funds remain suitable in light of such recent extreme market events, and that fund managers are working by the ways of their investment processes, not these psychological traps.