The last 12 months have been stormy, creating fresh opportunities to learn from some of the insights of behavioural finance.

For wealth managers and their clients, 2011 has been a tough year. Few strategies have coped well with the weakening global economy and extreme market volatility. The rollercoaster ride most portfolios have seen this year says little for market efficiency and traditional finance. But the experience does tell us a lot about investor psychology. If investors can learn from this, they could usefully apply more behavioural finance in portfolios next year. 

Increasingly, investors are recognising that they need to not only manage risk and return, but also to deal with the stress and anxiety that can arise. Buying a stock for a big projected gain will achieve little if share price volatility then triggers a premature sale. It can be hard to maintain focus on the destination if the journey proves too difficult. Even the most rational investor can be unnerved by fellow travellers in a stock if they have different time horizons and risk tolerances. Most find it a challenge to keep faith with a stock if its share price persists in ignoring fundamentals. This anxiety triggered a lot of the unhelpful trading this year that did so much damage to portfolios. 

For example, software group, ARM, a growth stock, has gained almost 40 per cent in the year. But many investors sold on the six days on which it fell more than 5 per cent. There were three times as many extreme positive days. Gold is up more than 20 per cent in 2011, but on the journey it fell 15 per cent in September.

The response of many investors to this anxiety has been to seek comfort in defensive stocks.  Fund managers know their clients like the term “quality stocks”, suggesting safety from stock market turmoil. Quality has a reassuring ring. It is generally applied to mega-cap stocks that are less cyclical, such as pharmaceuticals, telecoms and food and drink. The attributes investors like are size, ease of dealing and dividend yield. Certainly these sectors may be less economically-sensitive, but whether the businesses are really growing is open to question. Quality seems reassuring, but out-performance rarely comes when comfort is the main focus.

The description typically means that managers believe the stocks are less risky. But, expecting out-performance with less risk is unrealistic investor behaviour. The risks in quality stocks may be misunderstood, with a built in over-valuation driven by this investor love affair. Premium ratings can mean long term under-performance. Even worse, there can be a false comfort from the “halo” effect of presumed quality. As BP, the oil major, showed in 2010, even the largest and highest yielding stocks can carry risks that are far from obvious and certainly not reflected in low historic betas.

Owning the most liquid large stocks can result in closet indexing - clients are paying for active management but getting little genuine stock picking. And, it can even represent a lack of conviction, when managers prize mega-cap stocks for their ability to be easily sold in a downturn. Even though a client is a long term investor, they are paying a premium for an early exit they do not need. This may not be a good answer to anxiety.

Hard to spot the behaviours

Behavioural finance points to risks from loss aversion and crowd behaviour.  But, investor psychology can be more subtle; the impact of emotions on judgement is unconscious and not easily recognised.  So, how can investors address this? 

In 2011, investors may not have got what they wanted, but they did get experience that can be put to good use. However, it requires an unemotional, objective analysis of what happened. Trading activity needs to be calmly and critically examined, and the lessons learned for next year. Did changes during the year add value?  How far has an investment plan shifted from the strategy set out last January? 

Write it down!

A key way to bring objectivity to this appraisal is to maintain an investment journal. The simple act of keeping a notebook documents in black and white exactly what drove any change in position. Without a record, it is too easy to take a rose-tinted view of events; emotions rewrite history for us. But, with objective hindsight, an honest assessment is possible and lessons can be learned. This should set up a revised investment strategy for 2012, and also a useful set of investment rules. The best rules are those that arise from painful experience; the pain of loss and regret is at least twice as powerful as success. 

Behavioural finance is often criticised for its impracticality; challenging the neat maths and risk management of traditional finance, but not offering a complete solution. But it does have some answers; they just need to be more tailored to the psychology of each individual investor.

Recognising that the current market turmoil could persist through 2012 is good reason to develop a strategy to match that. Maintaining a dealing record, and learning from it, is a good resolution for the new year.