Client behaviour can harm long-term investing plans

A native of Helsinki, Oster earned a BSc (Hons) degree in management sciences from the London School of Economics. Also in London, she worked in mergers and acquisitions with Salomon Smith Barney, and in equity research with Goldman Sachs.

This investment-industry experience underscored a desire to understand how people make decisions. Previously in her undergraduate studies, Oster had completed a course in decision analysis. This time, her interests propelled her to doctoral studies at Stanford in San Francisco.

“When I saw how markets behaved, I got very interested in how you could actually combine the two — combine how people in real life behave, together with some of the theories about asset pricing and some of the more rational work,” says Oster. “Going back to academia allowed me to go deeper into these topics.” In addition to her studies at Stanford, she spent time studying with behavioural-finance scholars at Yale University.

After completing her PhD in 2008, Oster joined Barclays Global Investors, where she did research and portfolio management in the firm’s quantitative stock-selection business. (BGI merged with BlackRock in 2009.)

Beyond the halls of higher learning, Oster sees tangible lessons for investors in the main tenets of behavioural finance. For example, despite a prevalent belief that investors are able to process information efficiently and in an unbiased manner, the reality is, even highly trained experts are prone to deviating from the rational when making decisions. Conclusions based on everyday rules of thumb — known as “heuristics” in academic theory — can actually lead to bad decisions, explains Oster.

Using insights from behavioural psychology, Oster has identified some common investor missteps that often undermine investment success. The recently published iShares Market Perspective newsletter, Breaking Bad Behaviors — Understanding Investing Biases and How to Overcome Them, authored by Oster and colleague Russ Koesterich, BlackRock’s chief investment strategist and chief global investment strategist for iShares, looked at these issues.

Behaviours that are potentially detrimental to longer-term investment success include under-investing in certain types of assets. Oster counts a number of reasons why investors tend to shy away from “riskier” asset classes like equity markets and foreign securities.

“[This is] perhaps because people are not that familiar with the benefits of diversification or because they tend to go for assets they’re familiar with,” says Oster. “This is the home-country bias — going for known companies or their own country’s assets, the names of which they recognize.”

@page_break@ A related predisposition is buying into companies that have grabbed recent headlines, or stocks that have performed well lately. People tend to invest in such known names “even if there is little evidence to show that this would actually predict future returns,” says Oster.

Further, an extreme fear of market losses may deter an investor from investing in riskier assets and leads many to sit on the sidelines for too long, according to Oster. “Losses are more painful — some [studies] estimate the pain from losses to be roughly twice the magnitude of the happiness from a gain.”

This aversion also manifests in another potentially damaging habit. “People tend to sell assets that have done well, rather than the loss-making assets on which they could actually get a tax advantage through capital losses,” says Oster.

Finally, says Oster, trading too frequently is a common investing behaviour that has been shown to erode investment returns. “Oftentimes people exhibit some degree of over-confidence, and this tends to exhibit in trading too much,” says Oster. Interestingly, she adds, men are more prone to this habit than are women.

While Oster brings a perspective informed by academic theories to the investment process, the methodology she oversees is based squarely on fundamentals. “We run a systematic model overnight so that we can see the alphas-like return forecasts on a daily basis,” says Oster.

In global-equity analysis, for example, country and sector views are based on analysis of valuations, growth prospects, corporate sector profitability and risk/sentiment.

“When we decide on the weightings of these various factors, we look at how the markets have priced them in over time, across the different segments [such as] countries, and we therefore decide how much weight they should be getting today,” says Oster. “The crux of our methodology is really to look at what is currently priced in by the market and where we see further investment opportunity. We try to react to the market either overshooting or not fully accounting for something that’s out there.”

At the same time, understanding what may drive investor missteps isn’t a formula for knowing how markets will behave “There’s a difference between saying, ‘We, as individuals, may exhibit some of these biases,’ and saying, ‘There will definitely be a market reaction that is highly predictable either way.’ That is much tougher,” says Oster.