The Science and Psychology behind Investment Funds

Hackney carriages emerged in London in the early 17th century as a means of transport for the wealthy who would often hire them out; Hacquenée being a French word used to describe a general purpose horse. Arguably, this service carried out by the aristocrats of the 1600s sparked the evolution of the taxi industry we all know today. Since then, a lot has changed and mankind has become more sophisticated in refining the different vehicles used to get us where we wish to go. Selecting an investment fund is no different.

Investment funds have different forms and functions. Their nature or purpose has a lot to do with how they are structured. Graphite and diamonds are both made of exactly the same chemical element, namely carbon. How these carbon atoms are pieced together ultimately determines their physical nature. Layering carbon atoms creates graphite but, if you piece them together tetrahedrally, or like a triangular pyramid, you end up with a diamond.

The same principle applies when checking under the hood of your Investment fund. How the underlying investment instruments are pieced together has a direct result on the outcome of your fund. Having more or less weighting to one particular share, bond, fixed income or cash instrument or even an entire asset class can affect your overall performance over a given timeframe during a given economic environment. The structural combinations are many, with multi-asset funds having significantly more combinations to consider than single-asset funds.

The science behind effective fund selection should also be focused around the fund’s objective and the people that manage it. If the fund’s objective is consistent through all economic cycles, backed by experienced fund managers who have reliable long-term track records in successfully structuring the fund’s underlying instruments, the likelihood of stronger fund performance will increase. Therefore, a rational objective-based approach to fund selection that is both qualitative and quantifiable is essential. However, rationality or objectivity is not the only player on the field. Our decision making is also influenced by our own human psychology.

Well over 200 years ago, in 1759, before Adam Smith wrote the ‘Wealth of Nations’, he published ‘The Theory of Moral Sentiments’. Its contents covered the history of ethics as it was understood in the 18th century, and were used as course material for young students at the time. It is here that Smith showcased the incessant struggle between the ‘impartial spectator’ and our own natural human desires or ‘passions’ as he called them. The continual battle rages on today between rationality and emotion. Our own changing emotional states’ may go unnoticed by others but mostly ourselves. This seemingly covert behaviour will inevitably have an effect on our decision making.

A common misconception that some of us may have believed or even still believe today is that the infamous naturally occurring food additive, Monosodium Glutamate (MSG) is toxic to all humans. In the 1960s, an essay was published in a medical journal explaining a particular doctor’s adverse symptoms after food he ingested at a Chinese restaurant. The blame as it turned out was placed on MSG. According to the Food and Drug Administration (FDA) in the United States, there is no chemical difference between the naturally occurring glutamates found in food items such as cheese, ripe tomatoes and mushrooms and the stigmatized MSG-labelled shaker on the restaurant table or at our local grocery store. Although people’s sensitivity to any food additive is not to be ignored and large doses of any food additive should be avoided, the FDA officially states that MSG is “generally recognized as safe” for human consumption in normal quantities. People’s decisions around particular grocery items and certain restaurants have been heavily influenced by this general misunderstanding, mostly due to a lack of proper context. In other words, our beliefs shape our decision making.

The effect behavioral biases have on our decision making is probably more significant than we realise. Biases color our view of the world. Our perspectives are shaped by these powerful forces and our perspective of reality is the reality we understand it to be, which may not exactly coincide with what it actually is. Our own beliefs and accrued understanding of what is true and untrue about a fund, a company or even an investment philosophy can shape our decision making. Not only are our beliefs shaping our decisions, we are influenced by numerous others. Let's discuss a few of them.

The impact of the media on consumerism as a whole is extraordinarily powerful. Companies, their respective brands and investment products are all competing for your attention. Not only are they wanting the top spot in your mind, they want to remain your particular brand of choice for the remainder of time. Media campaigns that invoke a strong rooted emotional connection are more effective than those that don’t. In 2003, a South African asset manager hired an advertising agency to improve their brand awareness. Between 2003 and 2007, this particular asset manager’s market share grew over 300% and by 2011 their assets under management had grown exponentially.

What about social desirability as another bias? As human beings, at some point in our lives, in some way shape or form, we have sought the approval of others whether we care to admit this or not. Maybe it could be our desire to be in the same investment fund as those people we look up to, or that financial professionals including myself want to keep their clients happy by switching funds unnecessarily out of fear of losing them as clients altogether due to sluggish performance. Our differing emotional states justify our decisions despite what logic or rationality have to say. Social desirability bias has a strong influence in these circumstances and financial advisors can have a tough job protecting clients from themselves, especially in seasons of little or negative performance.

Finally let’s take a look at Recency bias. A fund or even an asset class’s recent strong performance over a given time period may swing the attention towards or away from investors and financial professionals alike. Although the rational part of our brains wants to sit us down and briefly re-explain that past performance is not an indicator of future performance, the temptation to believe the contrary is very seductive. To be fair, track records are necessary and are a reflection of what the asset managers are bringing to the table. However, a fund’s track record is never to be viewed in isolation or as the sole motive for choosing an investment fund. The contentious issue with past performance is that it will undoubtedly create an expectation in our minds of what the future could look like. And for Recency bias to exist, all that is required is an expectation!

Fund Selection should always be about what is best for YOU. Short-term outperformance is great and will always be well received, but it’s not the actual point of fund selection. Fund performance is a by-product of good fund selection and not a justification for it. Just because someone invests all of his or her capital in a pure equity fund, and experiences strong performance over a given timeframe during a given economic climate, doesn’t justify that the particular fund is best suited for his or her needs, especially if you find out the capital is limited and there is a requirement for regular monthly income that needs to be sustainable over their lifetime.

Experience comes with following an objective-based approach, being aware of one’s cognitive behaviour, getting the proper context, checking one’s motives and always acting in in your own best interest. Working with a financial coach to discuss and debate our fund selection in light of our behavioral biases is crucial, especially when it comes to our own money.