In matters of money, we're only human

By TONY SAVAGE*

Investors should take note of this year's Nobel prizewinner for economics, Israel-born US citizen Daniel Kahneman. His great discovery was that investors are human too - a novel theory which will change your approach to investing.

Once the Nobel Prize is awarded to a new model or discovery, theories previously thought of as unproved often become quickly accepted. In this case, the traditional approaches to investment did not find that human behaviour was a relevant factor in making money.

For the purpose of making the most money from investments, it has proved best to assume that the average investor accurately weighs up costs and opportunities and makes the choice that best suits the facts and probabilities.

However, Kahneman's recognition means investment theory will now incorporate how we actually behave as a valid part of the science of investment.

Exactly how will this affect investors? Finance has been concerned with answering the question "which strategy will make the most money". The difficulty has always been knowing how long to wait before deciding which method succeeds.

Right now, something of an impasse has been reached as to how to move forward. Are we there yet or do we have to wait longer to prove which of the various investment techniques provide the best payoff?

Some academics have begun to doubt if the techniques now available offer a solution. Kahneman offers a possible way out.

Kahneman owns a financial planning firm so he puts his money where his mouth is. His important discovery is that the psychology of investing can and should be an important tool in making money.

Take, for example, the discovery that people tend to dislike losing about twice as much as they like winning. Kahneman shared his prize with American Vernon Smith, who found a way to test such ideas in the lab with volunteers.

The dislike of losing provides insight into why most people - investors included - are far too optimistic.

Psychologists have thought for a while that optimistic people lead happier lives and may live longer. Optimism is a survival strategy. People who see reality as it actually is are often thought of as too pessimistic and may be unhappy. Perhaps that is where the jokes about accountants come from.

Because we are too optimistic, we believe we are skilful when luck and chance provide a better explanation. We underestimate the role of chance in our lives. After all, every day a one in a million chance happens to three New Zealanders!

A dislike of uncertainty means investors think they can control what they cannot. It means they buy high and sell low and follow others who seem to have the magic touch when they have probably just been lucky.

What is also interesting about Kahneman's discovery is that investment professionals and advisers are subject to the same unfounded optimism. They see skill when none is present.

They think they are better-than-average managers, despite numerous rigorous studies demonstrating that not only has this not happened in the past, but it is unlikely to in the future.

The role of an investment professional is not to try to predict the future. The stock market already has a mechanism that does the best job. It is called the price of an investment. Although often wrong and subject to bubbles and hysteria, on average price is the best guide to the value of investments where an open free market sets those prices.

Financial advisers will need to become better realists, tempering clients' natural optimism, providing discipline to the investment process and counselling against investing on the basis of optimism alone.

The question with all theories is this: "so what?" How will this change investment behaviour and advice?

One example is that investment professionals may learn to help clients to see their total wealth and not just the performance of individual funds or investments, so they are better able to tolerate risk. They can learn to focus on the factors they can influence and forget the rest.

Exactly when this will help investors to make more money is yet to be settled, but the work has now begun in earnest.

* Tony Savage is research director at Strategic Asset Management.