How the ‘human factor’ detracts from investment returns

The ‘human factor’ in investing is being increasingly recognised as both an opportunity and threat to performance. This was a theme of last week’s van Eyk Research annual conference and, yesterday, MLC Implemented Consulting added its weight to the discussion in its latest client newsletter.

Stephen van Eyk, managing director of van Eyk Research, addressed his audience on some of the great sharemarket and other investment bubbles of history, from the tulip madness of the 17th century to the tech boom and bust of the late 1990s/early 2000. MLC has studied the more common human frailty of ‘short-termism’. Gareth Abley, senior asset consultant at MLC, says that mankind’s genetic attributes, which have evolved over millions of years, are not conducive to successful investing. “We are programmed to herd, to react emotionally rather than logically, and to focus on short-term survival,” he says. “All of these tendencies detract from the returns we could achieve if we were capable of contrarianism, objectivity and long-term discipline – characteristics possessed by many of the world’s most successful investors.” Abley cites the US research which shows that while the sharemarket has delivered annual returns of about 13 per cent a year over the past 20 years, investors in US equity mutual funds averaged only 3.5 per cent. The gap is attributed to transaction and management costs and bad decisions. Neuroscience indicates that a tendency towards short-termism is at least partly due to genetic hard-wiring producing an urge to follow the herd. The psychological pain of being different is experienced in exactly the same part of the brain as physical pain. “While our evolutionary design encourages investors to be short term and follow the herd, the evidence suggests that a disciplined long-term approach generally delivers a better outcome… “Most investment managers respond to the signal provided by investors … by sticking close to benchmarks. This makes sense for them, but it results in products that are designed to meet investors’ short-term whims, not their long-term needs.” Abley says investors should adopt the similar attributes to MLC in its ‘Long Term Absolute Returns’ portfolio: a genuine long-term focus; the courage to be different; and the discipline to ignore the pressures (psychological and otherwise) that arise from performing very differently to the peer group.