One of the biggest challenges investors face is their own cognitive biases, which can prevent them from making the most objective and optimal decisions for their portfolio.
An average human is influenced by more than 180 cognitive biases, ranging from authority bias – where you tend to listen to perceived ‘expert views’ – or the often witnessed ‘herd mentality’ where you end up following the majority, often in times of crisis.
We believe beating these biases is key to the long-term success of an investor. That means not only helping our clients recognise when their biases are at play, but also making sure that our advisers themselves are as bias-free as possible.
Biases in practice
Our Investment Philosophy hinges on the art and science of human behaviour. In practice, we try to debias members of our Wealth Management Investment Committee, individually and collectively. The human brain always looks for causality behind different outcomes, even when the true cause cannot be observed. If you look at any financial report from the past few years, you will find explanations for why the US dollar rose or stock markets fell, playing into the tendency for the human brain to look for the causality of various outcomes. While this is not necessarily a problem all the time, we do tend to form shortcuts in our brain that use these explanations to try predicting what will happen in the future. That’s exactly when it becomes a problem, because often the correlation guiding our prediction is not what we perceive it to be and can often be detrimental to the accuracy of our forecasts.
A good example is the relationship between US interest rates and the US dollar. If asked what would happen to the US dollar if the Fed were hiking interest rates, most people would probably expect the US dollar to appreciate. However, the reality is that the US dollar is more likely to rise well before the Fed actually starts hiking interest rates. So the ‘cause-effect’ shortcut we had tried to build between the US dollar and Fed rates doesn’t in fact exist, but is how the market typically reacts - by anticipating the hikes.
These shortcuts are the main reason why our Investment Committee spends a lot of time trying to identify historical relationships, also called an ‘Outside View’ by Nobel prize winner psychologist Daniel Kahneman and leading behavioural scholar Dan Lovallo. For instance, one of the personalised advisory services our Private Banking clients can use involves running different scenarios to give a historical statistical perspective of asset class returns under each of these scenarios.
These scenarios often turn out different results, thereby reinforcing the need for the forecaster to acknowledge the uncertainty in outlook, reduce the emphasis on mental shortcuts and plan accordingly. This in turn encourages investors to have diversified portfolios. Some examples of the different Outside Views at can be examined using the following scenarios for US equities:
- If the US 12-month forward price-earnings ratio is greater than 18 (currently 22), then US equities have, on average, delivered -7% returns over the next 12 months, recording positive returns only 31% of the time.
- If the US equity risk premia (US equity market earnings yield, which is inverse of the price-earnings ratio, less the US 10-year US government bond yield) starts between 3-4% (currently 3.5%), then US equities have on average delivered +7% returns over the next 12 months, recording positive returns 84% of the time.
- If the US dollar weakens 5-10% over a 12-month period (our current view), asset class returns across the board, including for US equities, are generally higher than if the US dollar strengthens. For example, returns for our diversified global asset allocation model have historically been 13% under a weak-dollar scenario vs 2% under a strong-dollar scenario. The historical probabilities of positive returns under those scenarios have been 100% and 64%, respectively.
These are just three Outside View examples, but they give the sense of the challenge faced by investors by laying out the very different predictions you can work out for the same question depending on the historical scenario you use.
Today, bonds and equities are relatively expensive, yet cash is likely to lose purchasing power as inflation is expected to be above short-term interest rates. Our view is that this, together with a weaker US dollar, is likely to result in positive US equity market returns over the coming 12 months.
However, as the above Outside Views illustrate, this is far from being guaranteed and, therefore, it is important for investors to diversify.