The emotional hedge: three lessons for investors
Last year the Nobel Prize for economics was awarded to the American economist Richard Thaler, known for his “nudge” theory and a leading light in the growing field of behavioural economics. But the real breakthrough in behavioural economic theory came 15 years ago when one of Thaler’s peers – the Israeli-American psychologist Daniel Kahneman – proved that people deviate from logical choices for predictable reasons.
By crossing into psychology, economics began to develop and become much more relevant. But how many of these lessons have been learnt by the investment community?
Not many. When investing, we’re all happy with the concept that if you want more return, you need to accept greater risk. As a result, the focus of the investment industry has been seeking the best “risk-adjusted returns” for their clients. And taking on more risk without expecting any additional return isn’t clever. But a portfolio with the “best risk-adjusted returns” may actually be woefully incomplete in terms of what your best portfolio should look like.
We at Tribe Impact Capital commissioned Greg Davies PhD to try to understand why the risk-adjusted returns mantra might not be as universally suitable as we’ve been taught. In our paper, Investing for Real People, we found three lessons from behavioural finance.
Firstly, total returns from investing are both financial and emotional. But traditional investment approaches usually ignore the latter. Secondly, money is a means not an end. But typically investing only sees it as an end. And finally, good investing requires emotional comfort. But traditional investing tends to ignore concepts like comfort.
Lesson 1: What is a return?
Investments deliver two distinct types of return: financial and emotional. The latter is usually overlooked in traditional investment decision-making; it’s the value we get from owning something. This might come from a sense of satisfaction, enjoyment, or purpose. Collectibles are a common example: art investors may get a financial return from their holdings, but they will get an emotional return too.
Impact investing is another example. These are investments that seek financial as well as social and/or environmental benefits. So a portfolio of impact investments can deliver financial returns and an emotional return from the sense of purpose that your portfolio is supporting.
Lesson 2: Why are you investing?
Implicit in the drive to maximise risk-adjusted returns is the assumption that more money is always better. But money is a means and not an end; it is only valuable because it helps us get more of what we want. Studies that show more money does not lead to more satisfaction.
Yet what if some of what we want can be acquired through the process of investing rather than the proceeds? Imagine that even a fraction of what you plan to spend your money on includes some social or environmental benefit: things that you care about. Impact investing, with both financial and social/environmental goals, can get some of what you want, even while making money to get you more of what you want.
Money is a means and not an end; it is only valuable because it helps us get more of what we want
Lesson 3: Are you sitting comfortably?
The financially optimal portfolio may be right for a perfectly rational operator, but is seldom the best for a real person. Abundant evidence exists to show that uncomfortable investors make a myriad of poor decisions. The “behaviour gap” occurs when our emotions get the better of us: we are greedy when markets are expensive and fearful when they are cheap. This bias costs the average investor 1.5% per year.
An investment portfolio that expresses your values, invested in businesses with stories that resonate with you, and that reflects your beliefs, is one you are comfortable with. This type of portfolio provides a natural emotional hedge to the stress of markets.
If you are rational enough to recognise some of this, and human enough to realise it affects you too, you should start to think about the emotional return on your investments.
This article features in issue #9 of Pioneers Post Quarterly. Subscribe now here to get your own copy of the printed edition and to access much more online.