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Financial Markets: Calm seas never made a skilled a sailor

4 June 2024 David Fyfe

I grew up with a knack for numbers. Through my early years I always found maths something that came naturally to me which in turn sent me off on the path to become a Portfolio Manager, as I am today.  This journey was somewhat less traditional than some, but one that provoked an interest in financial markets at each turn. 

One of the earliest lessons that shaped my understanding of financial concepts came from my grandfather. He inherited a sizable fortune from a family farm in the South Island, worth over ten times the value of my parents' first house at that time. However, without any financial advice and limited financial know-how, he kept it all in a bank account. Decades later, by the time he passed away, my father inherited a far smaller amount, equivalent to less than a quarter of the value of the same house. The simple but painful lesson here for me was of course that he hadn't taken advantage of the great power of compounding returns, or as Einstein famously called it, the eighth wonder of the world. This realisation sparked my interest in financial markets in respect of generating returns and maintaining wealth, driving me to ensure that such opportunities are not missed. 

By the time I had worked my way through to university, I was interested in everything numerical – from economics, accounting, finance, statistics through to my final major in Operations Research. This subject is a discipline that deals with the development and application of analytical methods to improve decision-making. This led me to my first interaction with the fascinating world of behavioural finance.

When I first stumbled upon the works of Daniel Kahneman and Amos Tversky during my early university years, I had no idea that their insights would nudge my career path towards investment management. Their groundbreaking, and at the time somewhat unconventional, research on behavioural economics opened my eyes to the hidden forces driving our financial decisions, forces that traditional economic theories and textbooks often overlook. 

One of my early lessons from Kahneman and Tversky was about cognitive biases, particularly the availability heuristic. This concept determines that we judge the likelihood of events based on how easily examples come to mind. Think about it: after a highly publicized shark attack, everyone suddenly becomes wary of swimming, even if statistically, the chances are incredibly low. In the financial world, a recent market crash can leave investors anxious, leading to decisions driven by fear rather than logic. You only need to look to many economic forecasts made, which often just reflect current conditions. Understanding this bias has been crucial in helping me navigate uncertainty and volatility to help make more balanced investment choices. 

Another gem from their research is prospect theory, which describes how we perceive gains and losses asymmetrically. We feel the pain of a loss much more acutely than the pleasure of a gain. Picture yourself on a deep-sea fishing trip: catching a small fish feels rewarding, but losing your prized catch at the last moment is heartbreaking. In markets, this means investors often hold onto losing stocks too long, hoping to break even, or sell winning stocks too quickly to 'lock in' gains. By recognizing this behaviour, I have developed strategies that help mitigate these knee-jerk reactions, encouraging a more disciplined approach to investing, especially on buy/sell decisions. 

Framing effects, another cornerstone of Kahneman and Tversky's work, reveal how the way choices are presented can influence decisions. Imagine being offered two boats for a voyage: one described as "90% safe" and the other as "10% risky." They’re identical, yet the former sounds much more appealing. In finance, presenting a market correction as a "buying opportunity" rather than a "crash" can significantly alter investor behaviour. This insight has been invaluable in how I communicate with clients, framing situations to help them see the potential rather than just the risk. 

Overconfidence bias is yet another intriguing concept. It’s like believing you're an expert navigator after a single successful trip. In investing, this overconfidence – an all too common bias -  can lead to excessive risk-taking. By constantly reminding myself of the limits of our knowledge, I aim to keep my feet on the ground, ensuring that we make decisions based on thorough analysis rather than arrogance– acknowledging what we don’t know. Often the ability to step back and reassess oneself and reflect on decisions can be of higher value than the decision itself. Everyone needs a good dose of intellectual humility! 

Finally, there's the Richard Thaler term - endowment effect, where people overvalue what they already own. Just as sailors might cling to their old, trusty boat despite its wear and tear, investors often overvalue their current holdings which can lead to longer holding periods that would otherwise be expected. Recognizing this bias helps in making more objective decisions, considering market realities rather than emotional attachments. 

Reflecting on my journey, I realise how Kahneman and Tversky's insights continue to influence my approach to investment management. They've taught me that understanding human behaviour can be as important as understanding market fundamentals. By blending these behavioural insights with financial acumen, I strive to guide through the vast ocean of financial markets, navigating the waves while avoiding the hidden currents. 

As I continue to explore the fascinating interplay between psychology and finance, I always recall the wisdom of Kahneman and Tversky, and the personal lessons from my grandfather. Their work and his story remind me that behind every market move is a human story, filled with quirks and biases that make the journey as unpredictable as it is thrilling.  

Disclaimer: David Fyfe is the Portfolio Management for the Mint New Zealand SRI Equity Fund. The above article is intended to provide information and does not purport to give investment advice.

Mint Asset Management is the issuer of the Mint Asset Management Funds. Download a copy of the product disclosure statement.

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