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Overriding our hard-wired biases helps cut out investment losses, behavioural economist Paul Craven tells EPRA workshop

Real estate is infamous for asset price bubbles caused by natural human biases skewing investment decisions, said behavioural economist Paul Craven, the guest speaker at EPRA’s Reporting and Accounting workshop in Paris in mid-April.

Paul Craven

Paul started as an industry speaker and consultant on Behavioural Economics in 2014 to help clients enhance their communication, investment and sales skills. This followed almost 30 years in the investment industry with Schroders, PIMCO and Goldman Sachs Asset Management. He is a visiting lecturer at the London Business School and, as a magician, a member of the Magic Circle.

“Economic history is littered with examples of bubbles fuelled by humans’ hard-wired herd instinct and confirmation bias,” observed the British consultant, who helps companies and individuals gain a competitive edge by understanding the psychology of human behaviour.
Real estate bubbles triggered or contributed to the global financial crisis, Japan’s ‘Lost Decade’ and the UK’s recession in the early 1990s, he remarked in an interview for EPRA Magazine. “What made the consequences much, much worse was the excessive use of leverage – the tendency to add more and more debt when the market was rising.”
Successful investors over the long term are generally those who make fewer mistakes than their competitors, so reducing errors caused by our instinctive biases requires constant re-evaluation and questioning of an investment, said Craven, whose insights on investing stem from his 27 years at Schroders, PIMCO and Goldman Sachs. He recommends compiling a checklist to avoid repeat mistakes, keeping an investment diary to log the decisions behind an investment and seeking the broadest range of views, particularly those that challenge the consensus.
“Behavioural economics isn’t about finding the Holy Grail of investing; it’s about recognising that we often aren’t as skilled as we like to think we are,” said Craven. “It can be really helpful in mitigating and reducing mistakes so that people lose less money.”
For example, a fund manager who is losing money with a particular investment is more likely to risk holding onto it in an attempt to recoup losses, whereas the same manager might not invest new sources of money into the same investment because it has already incurred losses, said Craven. Conversely, gains in an investment can lead to risk aversion, so that investors often take a profit too soon, he observed.
Craven explained to the EPRA audience how primaeval survival instincts dating back to the beginnings of mankind might shape our decision-making. It is intuitive and very powerful – like an elephant with a rider sitting atop, to use a metaphor from psychologist Jonathan Haidt. “The rider, who represents our rational, analytical self in the metaphor, is almost powerless to control or steer the animal when it responds to fear, hunger, anger or other instincts,” said Craven.
Indeed, following the herd is a bias based on our ‘safety in numbers’ survival instinct, but “when you take it out of the environment where it’s needed and apply it in a somewhat artificial environment like a financial market, it makes little sense,” he remarked.
Closely related is the human bias to conform, which leads to the “if everyone thinks it’s a good investment, it must be” approach to investing. Psychologist Solomon Asch highlighted this in a series of conformity experiments in the 1950s that found individuals often suppress their own views when they contradict the majority group view, even if the consensus appears to be wrong.
Contrarian investors are therefore often successful precisely because they are prepared to challenge the consensus, summed up by billionaire investor Warren Buffett’s observation in his 2004 letter to shareholders of Berkshire Hathaway: “Be fearful when other people are greedy and greedy when other people are fearful.”
There is plenty of evidence of this herd mentality in the flows of retail investors’ savings into hot securities, funds and the housing market, said Craven. “People tend to get too bearish and sell when a market or asset price is close to its bottom, whereas they often become too bullish when it is close to its peak.”
“There’s a lot of confirmation bias in the property sector because people live in bricks and mortar, so they are very keen to push it as an investment,” he continued. “This is why it becomes a regular topic of conversation at dinner parties, whereas we don’t generally make polite conversation discussing the bond yield curve.”
Another example is ‘groupthink’ in decision-making bodies, where there is no dissenting voice or no-one to challenge authority. Craven gave the example of the school that distributed pencils to pupils with the message “Too Cool to Do Drugs,” overlooking the fact that as the pencils got sharpened, the well-intentioned message shortened to “Cool to Do Drugs” or “Do Drugs.”
He coupled this example with another bias, that of hindsight or the ‘We knew this all along’ perspective: we are all experts after an event, in this case how ridiculous the pencil idea was. Likewise, we often create a narrative to explain any event that may have been unpredictable at the time: humans like to make sense of the world and often eschew randomness as a factor. This can distort decision-making and lead us to the wrong conclusions, he added. Keeping a decisions diary helps an investor remember what went into an investment decision at the particular time, countering hindsight bias that may lead to repeat mistakes.
Craven’s concluding recommendation for investors is to be highly sceptical when there is a growing consensus in markets of a ‘new paradigm’ or the ‘it’s different this time’ narrative because of the natural biases in human thinking.
For this reason, Craven is particularly fond of the quotation ascribed to writer Mark Twain that “history doesn’t repeat itself, but it often rhymes,” which aptly describes the natural rhythm that human behaviour gives to financial markets.