Quantum investing: the observation of an investment journey changes its nature
When is the same investment return not the same investment return?
In the graph below are three investment journeys. They all start and end in the same place. Without overthinking it, what is your intuitive answer to these questions: Which investor would be happiest with their returns at the end? Which would your client rather have experienced?
They’re simple questions, with a complicated range of possible answers.
For over a decade, I’ve shown this graph to thousands of people all over the world. The answers are remarkably consistent.
About 5-10% pick the green line, with the remainder equally divided between black and blue. Abstaining is also an option, but makes next to no difference as no one ever picks it. Not only does everyone have an opinion; those opinions tend to be strongly held.
There are myriad reasons to pick each line, the main ones being:
No answer, nor any specific reason for any answer, is ‘correct’. There is, however, an answer that is incorrect.
Classical finance asks us to believe the journey does not matter. That is a mistake. Ignoring strong intuitions of the investors who have to endure the journey is always a mistake.
Ask not what you can do for their questions, ask what the questions can do for your clients
The answers themselves don’t matter. The fact that different people see different answers, and that these reflect their personality, does.
In the words of Alain de Botton, “The worth of sights is dependent more on the quality of one’s vision than of the objects viewed.” The investment return you secure for your client comprises both the money and the emotions they attach to its movements along the way.
Asking the question and attending to the answer matters because investing decisions, like all decisions, are ultimately made by our emotions. How happy the three investors are at the end is merely interesting; but the fact that their different emotional states will affect every investment decision they make next is crucial.
This is particularly pertinent at the moment given the heightened volatility in stock markets this year owing to the Covid-19 crisis.
When investors lack comfort with their portfolio, they will act in costly ways to acquire it. And not all of those ways are created equal. Not investing at all is more costly than paying for an adviser to hold their hand through the journey, which – let’s face it – is more costly than simply not looking at their portfolio so frequently.
This is where behavioural science comes in. Until now, looking at personal responses to the journey could only describe what was going on; a proper profiling process turns these descriptions into prescriptions for how clients can invest better.
Behavioural profiling is important because it allows us to predict in which ways our clients are likely to tend towards poor decisions, and helps us to deter them from doing so. It helps us to provide the emotional comfort they need in a cheap, planned and efficient way, rather than the knee-jerk and expensive methods they may clutch at when left to their own devices.
Because ultimately making better decisions isn’t just a theoretical exercise.
The graph below shows three real-life journeys that match our theoretical scenarios. In each of the 10-year periods investors received the same returns, and each involved a traumatising market crash, at the beginning, middle, and end respectively. But most important is what’s not shown: the investor’s emotional state and its longer-term consequences. Despite having substantially increased their money, the client would feel vastly different in each case. And they’d lean towards very different, and emotional, decisions as a result.
Investing has after-effects. Early investing experiences can profoundly shape later ones. This makes it even more important to manage bad emotional experiences, in whatever form they’re most likely to arise.
Returning to our theoretical journeys, a final lesson is that with some effort we can help all our clients turn the green or blue lines into the black one, if they wanted. All they need do is avert their gaze for the duration of the journey. If a portfolio falls and they’re not watching, did it really fall for them?
What you, and your client, choose to see depends less on the object and more on the eyes you’re using to look at it.
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About the author
Greg B Davies, PhD - Head of Behavioural Science, Oxford Risk
Greg is a specialist in applied behavioural finance, decision science, impact investing and financial wellbeing.
He started the banking world’s first behavioural finance team at Barclays in 2006, which he led for a decade.
In 2017 he joined Oxford Risk to lead the development of behavioural decision support software to help people make the best possible financial decisions.
Greg holds a PhD in Behavioural Decision Theory from Cambridge; has held academic affiliations at UCL, Imperial College, and Oxford; and is author of Behavioral Investment Management.
Greg is also Chair of Sound and Music, the UK’s national charity for new music, and the creator of Open Outcry, a ‘reality opera’ premiered in London in 2012, creating live performance from a functioning trading floor.
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