The behavioural drivers of stock markets

Being human can get in the way of good investment practice. All investors are subject to behavioural biases that can see them make irrational decisions, and fund managers are no exception. A vital part of investment analysis should involve looking at whether fund managers are making decisions rationally

Behavioural biases are always in evidence in financial markets. Fund flows tend to increase when markets are high, but buyers often evaporate after a slump in share prices. They are being offered the same product at a lower price, but are hesitant to buy.

This phenomenon has a name - ‘herding’. Investors can be swayed by the wisdom of crowds: when markets are rising, they are encouraged to buy, but they are reluctant to go against the tide when markets fall. Herding has characterised every bubble in history. In the short-term, investors are whipped up in the excitement of rising share prices, but it is difficult to judge when it will end, and painful when it does.

Fund managers may be vulnerable to herding in more subtle ways. They may want to avoid career risk by sticking close to their peer group, for example. They may be reassured by the popularity of a stock with analysts.

Over-confidence

If fund managers have a strong run of performance, they can start to believe they have the magic touch. This may see them lose discipline, or place too much reliance on instinct over sound fundamental analysis. ‘Hindsight bias’ is a similar concept whereby fund managers believe they have correctly predicted past events, which gives them too much confidence in their ability to predict the future.

Closely related to this is ‘confirmation bias’, where a fund manager starts with a view on a stock, and then looks for evidence to support that view, rather than vice versa. They may be guilty of ‘falling in love’ with a particular management team, overlooking their flaws, or failing to see a company’s manifest weaknesses because it has previously been a strong performer.

Fund managers may also be prone to ‘anchoring’ – believing that the future will be governed by the rules of the past. A share price will not fall below a certain level because it has not done so in the past, or demand for a product will be sustained because it has been strong recently. We want to ensure that fund managers are looking at their portfolio holdings objectively, based on the prevailing environment, rather than being swayed by past performance.

Survivorship

Another key behavioural aspect is the concept of ‘survivorship’, which describes the error of concentrating on something particular that makes it past a selection process whilst inadvertently overlooking something that did not. We are wary when an investment manager showcases the performance of a flagship fund but fails to highlight the fact that it exists solely because other funds have fallen by the wayside due to weaker returns.

It might be suitable for a fund manager to show strong performance over the past 20 years, but what if the same manager also had two other funds which were liquidated following weak returns during the financial crisis in 2008? The performance history of all funds should be presented and scrutinised.

Solutions

Every manager comes with certain biases and we would be naturally cautious if they claimed otherwise. However, it is important to identify that a fund manager has put processes in place to ensure those biases do not get in the way of good decision-making.

What does this look like in practice? It will usually mean an experienced investment team and a structured approach to portfolio construction. While there may be a strong lead fund manager, they need to have robust checks and balances in place to support their decision-making. Mistakes are made when an individual is given too much control and their decisions go unchallenged.

We like to see a strong and dependable investment process. This can help impose a discipline on fund managers and avoid many of the behavioural mistakes. It is also useful to ensure that managers are not deviating too much from their stated approach. This can be an early sign of problems.

Fund managers are human and vulnerable to making mistakes. However, these behavioural traits can be managed effectively. It is vital that all fund managers have the right tools in place to ensure more rational decision-making.

Download 2021 Charity Survey

IMPORTANT INFORMATION
This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. The value of investments and the income from them can go down as well as up. The investor may not receive back, in total, the original amount invested. Past performance is not a guide to future performance

Smith & Williamson Investment Management LLP
Authorised and regulated by the Financial Conduct Authority
Smith & Williamson Investment Management LLP is part of the Tilney Smith & Williamson group.
© Tilney Smith & Williamson Limited 2022

Ref: 21120400