What biases do investors face when assessing their portfolio returns? Dr Benjamin Holdsworth underlines the importance of a well-diversified portfolio.
By and large, behavioural science suggests that human beings make lousy investors.
While we are excellent problem solvers, we suffer from a whole host of well documented biases that, on average, erode the investment returns on offer from markets.
Being aware of our biases is a useful exercise if we are to limit the impact that they have on our decision-making.
These biases are well known in investing and have specific names. For example, we should consider the issue of ‘anchoring’ – the tendency to be influenced by a particular reference point or ‘anchor’.
There is also ‘recency bias’ which is overemphasising the importance of more recent experiences relative to older ones.
Today’s capital markets are extremely well integrated, costs are low and anyone with internet access can use the power of Google – or even perhaps ChatGPT? – to conduct their own research. However, historically investors have favoured companies listed in their home country as opposed to those abroad.
Partially, this was down to the additional cost, complexity and unfamiliarity of investing overseas, although these hurdles are relatively negligible nowadays. Even so, recent data tell us that ‘home bias’ – the extent to which the home country is weighted in a portfolio over and above its market weight – persists.
Perhaps anchoring to the performance of one’s domestic market is to be expected given the above.
For UK investors, the FTSE 100 measures the performance of the largest 100 firms listed in the UK and is frequently quoted in newspapers and media outlets. For some time, the UK has performed dismally when compared to international (ex-UK) developed markets.
For example, the decade of the 2010s saw the FTSE 100 companies return 75% to investors while international equity markets delivered a staggering 255% in GBP terms.
Since the start of 2021, the roles have reversed with the FTSE 100 delivering 31% versus 16% from international markets.
Recency bias is often witnessed in sports fans – perhaps betting on a team on a winning streak even though recent success might not indicate future play.
Similarly, if we look at shorter and longer period returns of the FTSE 100 and global developed equities, we can see how recency bias might work.
Over a 12-month period, the annual return might show that the UK has generally lagged global figures even when it has enjoyed a handful of periods of outperformance.
Yet if we look at ten-year time- frames, the viewpoint might be the opposite.
Getting swayed by recent performance, and perhaps anchoring to one’s domestic market, is best avoided.
If we think more about risk rather than performance for a moment, there are also some very sensible reasons why having too many eggs in the 100 largest UK companies makes little sense from an investment portfolio perspective:
This is because:
The FTSE 100 is highly concentrated with over 33% of the assets held in just the top ten companies – the likes of Shell, HSBC and AstraZeneca.
The FTSE 100 is ‘overweight’ – holds more than the benchmark –to certain sectors such as energy (12% vs 5% globally) and underweight – holds less than the benchmark – to the point of almost not having any in terms of technology (1% vs 21% globally).
This explains much of the recent performance differential above, where technology has struggled, energy stocks have flourished in the high-inflation environment, exacerbated by the Russian invasion of Ukraine.
Over longer periods, technology stocks have dominated – Apple, Microsoft, Tesla and so on.
You have the potential to own shares in more than 10,000 companies across more than 50 countries. Diversifying across them all as a starting point makes good sense and should lead to a smoother investment journey.
Be aware of the ‘anchor’ and make sure that you do not get overly influenced by what has just performed well. We cannot know which market will do well next, so we own all of them.
Dr Benjamin Holdsworth (right) is a director of Cavendish Medical, specialist financial planners helping consultants in private practice and the NHS
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