Behaviour biases cloud investment decisions as investors shun expert advice
In early April, a court in Hong Kong handed down a judgment about a dispute between a major bank and a client, dating from the global financial crisis.
The bank was claiming nearly US$3.5 million from the client for not meeting his margin calls as share prices fell. Margin calls top up a client’s account as the assets fall and it implies a high degree of borrowed money.
The client counterclaimed for mis-selling, contractual irregularities and breaches of the Securities and Futures Ordinance. The court found for the bank - but the result is immaterial.
This dispute, and the client’s loss, should never have happened and represents an utter failure of the system: bank, client and indeed regulator.
Primarily it is an instructive lesson on the behavioural psychology of clients and the role emotions play in their investment decisions. The lack of an analytical approach makes them highly sensitive to behavioural biases in their investment decision-making.
Those who become very wealthy inside just a generation find their skill with industrial or property investments do not carry over to the financial markets.
In Hong Kong, many investors like to make fast decisions and hate to lose face.
They are whipsawed by every small piece of news. They hunger after return - and deride risk management. They are typically untrusting and yet after short periods of success will completely trust a bank’s recommendations. They rarely read the large print, let alone the small.
Clients made money in the few years before 2008 mainly because the market went up - but it was enough time for greed to eliminate fear.
The banks fed off this behaviour, reinforcing the message with images of too-young-but-serious, booted-and-suited trusted advisers in expensive offices. As service providers, the banks felt that if you didn’t give a client what he wanted, someone else would; so offer it - and make it “exclusive” and “exotic”.
Structured products were ideal, with apparently high and stable returns, and were synthetically constructed by combining derivatives, so every one is different.
And they had cool names like this example: Two Year USD Periodic Callable Variable Maturity Range Accrual Equity-Linked Note in respect of shares of Sun Hung Kai Properties, CNOOC and China Life Insurance.
Not easy for an untrained investor to comprehend – and why would anyone need to invest in a combination of the share derivatives of companies in such diverse sectors as Hong Kong property, Chinese oil and Chinese insurance?
Is there any relationship between the underlying shares? What is the value of each individual investment? Does the client have matching liabilities with the stocks? Or does the combination just provide a synthetic return through a temporary mispricing of the derivatives?
Beneath such products was often a nasty secret. The promised returns actually resulted from taking on huge risk; such that if the market fell, the losses could be many times the potential gains.
But Asian investors don’t worry about risk, do they?
Clients in this part of the world suffer from overconfidence bias – what can go wrong? “I will get out before it starts to fall”. Self-made success breeds a resistance to wise advice, known as expert bias.
Most clients thought the bank was their expert but, legally, the banks were merely facilitating badly behaving Asian clients.
In one case, even hiring a personal investment manager did not help the client avoid losses. That expert was an inexperienced, low-paid hired hand and his presence merely clouded responsibility and judgment.
Asian clients follow the herd – the chat over dinner is about investment success – never about lessons learned; about returns, never about the risk taken.
They invest in latest idea (recency bias), or one heard more than once (repetition bias), or to get rid of that nagging private banker calling at 3.45 pm because “otherwise you’ll miss out” (attention bias). Then there is attribution bias – the ability to blame everybody else.
Professional money managers are more likely to fall foul of analytical biases rather than these biases of emotion.
You are not a gifted investor because you are rich, or spent three years at Goldman’s as an analyst, or an expert, or follow the herd, or have an inside track to exotic products.
You earn it by thinking about risk for a long period of time and understanding that return is a resultant of the risk taken. Good risk management avoids big losses that destroy returns.
Remember the old market mantra, “there are no professional investors, the best of us are merely gifted amateurs.”
Richard Harris is chief executive of Port Shelter Investment Management