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What can a top British cycling coach teach investors?

Image: British Cycling

Behavioral economics seeks to bring scientific rigour to trading

For decades, behavioral psychologist have proved that people show irrational biases when it comes to financial decision-making. A popular experiment shows how this works. If you are offered £100 with no strings attached, you are more likely to take it than having the chance to win £200 - or nothing - on the flip of a coin. On the other hand, if you were offered the choice of losing £100 for sure, or flipping a coin to lose either £200 or nothing, most people chose the second option.

It turns out that, regardless of the experiment, we are psychologically disposed to seek out risk when it comes to avoiding losses and to avoid it when it comes to making gains.

When it comes to investing this "loss aversion" manifests itself in when we are likely to buy and sell stocks: to avoid a feeling of regret people tend to sell winning stocks before they should in order to ‘cash in’ their profit, and to hold onto losing stocks in order to avoid cashing in a loss.

The effect is considerable. US academics Brad Barber and Terry Odean investigated the trading records of 78,000 investors at the same large discount brokerage firm in the US, over two time periods in the 1980s and 1990s (publishing the research in 2011). They found that investors were nearly three times more likely to sell stocks that have gained 18-22 per cent since they were purchased than they were to sell stocks that have gained between 2  and -2per cent (ie lost 2 per cent in value). Negative returns also increase the likelihood of selling: investors are only twice as likely to sell those that have gained 18-22 per cent as they are to sell those that have lost 18-22 per cent.

Not only is the disposition effect striking when it comes to investing in stock markets. It is also expensive. A 2004 paper showed how much better off investors in Barber and Odean’s study would have been if they had held onto their winning stocks. A survey of US equities found that those that outperformed the market average over the last six months have higher returns on month seven than stocks that under-performed the market average over the last six months. If Barber and Odean’s investors could have resisted their winner-selling compulsion for just four more weeks they would have been better off.

What should investors make of this discovery? One approach is pursued by Richard Thaler, a founding father of a new branch of economic discipline – called behavioural economics – that combines the insights of modern experimental psychology with economic theory. He has set up and investment management firm that manages more than $2bn, to develop strategies that spot where biases will occur in other traders and dive in to exploit the inefficiencies these create.

What should investors make of this discovery? One approach is pursued by Richard Thaler, a founding father of a new branch of economic discipline – called behavioural economics – that combines the insights of modern experimental psychology with economic theory. He has set up and investment management firm that manages more than $2bn, to develop strategies that spot where biases will occur in other traders and dive in to exploit the inefficiencies these create.

Another is for investment managers to train themselves to avoid falling into these cognitive traps in the first place. This approach has been adopted over the last year by a number of UK firms, including Schroder’s, GLG Partners and JL Hambro.

The techniques they are employing combine the number-crunching power of big data and the motivational skills of one of Britain’s most celebrated Olympic coaches.

The process starts by creating a database of every decision a manager has ever made. The research from experimental psychology shows that we are all subject to cognitive biases – loss aversion is one that is particularly widespread. But which biases we succumb to and when differs considerably from person to person.

“We analyse every single decision the manager has made and then play these back to them to show them the sorts of mistakes they are making,” says Rick Di Mascio, whose firm Inalystics provides the services to these firms.

Motivational training

Once the manager’s individual biases are isolated and measured, the motivational training begins at the hands of Shane Sutton. Sutton is one of the chief architects of the rapid rise to greatness of the British cycling team over recent years. He is comfortable with the complex statistical analysis of managers performance that Di Mascio’s team supplies him with: on the cycling track he has an obsession with detail from the time riders start training every day, to how their relax, to which materials on a rider’s jersey most reduces wind resistance.

He carries this approach into his work with his investment clients, what they are eating, their working hours and how they break them, social and personal pressures outside work, how they relax and when they sleep.

What elite sports and financial management have in common, he says, is the need to make complex decisions under pressure. It’s precisely under pressure that biases are more likely to emerge. Once managers can see how and when they are making mistakes, they can start to train themselves to avoid them. This involves looking at how they prepare themselves for work.

“We’re not trying to make these people into robots; the reality is that everyone wants some form of coping strategy,.”

Sutton says he’s surprised at how much professional investors he works with rely on “gut feel”. “Frequently they don’t use the information that is available to them and that is a pathway of the training: to show them that they should be working always from the evidence.”

It’s particularly surprising, he notes, given that investment managers are a high achieving and competitive group. But he’s not pretending he would be able to do any better.

“I had a go and lost about £5,000 in no time,” he says.

Hugo specialises in business and financial themes, writing and/or editing for a number of publications including Asian investor magazine, Global Investor Magazine and Institutional Investor.

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