As an investment consultant I had the privilege of researching different investment managers and learning about their techniques and processes for selecting companies and building portfolios. A large part of the research process would focus on fairly mundane due diligence questions, but there was always something a little magical when the interview got to that part when the portfolio manager was asked what it is he or she saw in the company; why they chose to invest. Often this would be the moment when the portfolio manager – be they relatively new or seasoned professional – would light up and start to tell a story. It was what I liked to consider the ‘human’ moment. It didn’t matter whether the company was in the pharmaceuticals, telecoms or industrial sector, it was the point when the idea behind the business made sense because it was something to which we could all relate: why would we buy a particular product – what difference would it make to me, my friends or family? To me, that is what investment comes down to. It puts the individual thought at the heart of the decision, rather than assuming some aggregated mass of decisions or ‘invisible hand’ pushing and pulling the price of a company.
Of course, such a simplistic statement gives no credit to the countless theories, brilliant mathematical and statistical models produced or millions of words written on the topic of investment. But it does reflect what I see as an increasingly growing focus at the heart of how we make investment decisions: simply put, human behaviour.
Integral to the assessment of a company’s equity capital reside models such as the Capital Asset Pricing Model (CAPM). Underpinning CAPM are the assumptions that markets are efficient and formed of rational, risk averse investors seeing to maximise returns. In fairness, any text book referencing CAPM will highlight the theoretical nature of the model and point out the short-comings of the assumptions. But it is the actions of the individual faced with investment decision that are increasingly and, in my view rightly, facing greater investigation. Do we act rationally and logically? Certainly, it would seem that the context of the decision is important – does the decision involve a loss or profit? Prospect theory[1], for example, would suggest that we would act differently and contrary to the ‘rational agent’ in situations where we run the risk of losing as opposed to gaining something. Similarly, do we have biases – cognitive or emotional – that influence our decisions? The answer to that question is undoubtedly yes, but are we able to honestly identify when we are suffering from those biases or, more importantly, take steps to adjust for them? Although somewhat nascent, I think we are starting to see the development of strategies to make us more aware of decision-making biases and techniques to adjust for those predispositions. But there needs to be more – not just in relation to investment, but in all forms of decision-making.
The natural extension of the psychological examination and assessment of how and why we do things is to delve deeper into the neurobiological science – an emerging field called neurofinance that looks at the different parts of the brain making decisions and the impact of hormones on, for example, risk taking.
So what I have characterised in the opening paragraph for me as that ‘simple, human moment’ is now under greater scrutiny and examination, perhaps even more than the maths and statistics more typically associated with investment. It is moving investment theory and practice into unfamiliar fields. Andrew Lo in his brilliant book ‘Adaptive Markets’ sums it up better than me:”…investors and financial markets behave more like biology than physics, comprising a population of living organisms competing to survive, not a collection of inanimate objects subject to immutable laws of motion.”[2]
I think this is to be welcomed as, aside from the insightful advancements the academics in this field are likely to bring to enrich financial theory, it may also help to locate investment as a tool of society, formed by society rather than an abstract practice on the periphery.
[1] Kahneman and Tversky, 1979 [2] Adaptive Markets – Financial Evolution at the Speed of Thought, Andrew W. Lo.
