There’s an enormous amount of research on behaviour that results in better investment performance and, indeed, Robert Thaler won the Nobel Prize for Economics 2017 for his insights and other behavioural economists such as Daniel Kahneman and Amos Tversky have produced valuable research.
Here are some thoughts for how an imaginary online stock broking firm could work if it was trying to use behavioural economics to improve the performance of investors using the platform:
1. Ensuring adequate research
The most basic rule of investing is to ensure that before buying a share the investor has properly researched both the company and the management team.
The investment platform should ask six questions before allowing the user to buy a stock in a new company that they have not invested in before. For each question they get wrong they should be banned from buying the stock for that many months.
2. Preventing over trading
Most stock trading platforms charge a lower fee the more an investor trades. This rewards behaviour that is destructive to creating wealth. A much better approach is for the first trade to be free and subsequent trades to become progressively more expensive as volume increases.
In other words a behavioural platform should have the opposite charging structure of all current stockbrokers.
3. Benchmark investors against their peers
Every investor on the platform should be notified of what performance quintile they are in compared with the other investors.
They should also be shown the behaviours of the top investors and how their behaviour differs.
4. Ensuring sensible diversification
Most platforms report on diversification in terms of category and country. This is very crude.
I’m not aware of any platform that shows portfolio diversification by date of founding of the business or by business stage (loss making, high growth or profitable, stable). Also it would be sensible to split by market capitalisation.
Incidentally, all platforms I’ve looked at show diversification by country based on the registered office of the company. It really should be on the basis of revenue split.
I also think the platform should warn against over diversification. No more than one new stock should be allowed per 6 months.
5. Financial metrics
It’s a very tricky thing to try to come up with a magic formula for investing. A very recent example would Carillion whose huge dividend yield resulted in private investors piling in before their bankruptcy. Institutions meanwhile are busy putting funds into “smart beta” products which sound too good to be true.
The central thing to understand is how good the company is at investing cash. Most publicly traded companies are profitable. The real winners understand how to invest their profits (or other cash flows) to make even more profit in the future. This is the reason I love companies like Amazon and Berkshire Hathaway.
Debt is also a metric that’s worth looking at properly. Debt in itself is not a bad thing but it is concerning if debt is being used to fund dividends or if equity is being replaced with debt during a period of historically low interest rates. However in a company going through growth where debt is rising to fund capital expenditure, increasing debt would be a positive.
My fantasy investment platform would try to show how effective the business was at investing and whether the debt was good or bad.
Valuation is of course the most widely viewed metric. I’m not sure I have a simple answer to this. Everyone wants to buy cheap and sell high but most investors fail to do this.
There have been brilliant investments that have always had a high valuation (such as ASOS or Netflix). However my view would be to avoid overly expensive investments, of course this will result in the investor missing some opportunities but overall it’s a better behaviour to buy at fair to low prices (so-called value investing).
6. Beta blocking
Traditional investment theory is very tied up with volatility (R-squared value in terms of a benchmark). It’s the basis of the Capital Asset Pricing Model (CAPM) which gives a view on what return is required for a given level of risk.
It is however complete bollocks for the great majority of investors (the exception being investors who are just about to need liquidity such as people just about to buy an annuity or with children about to start University).
Very few homeowners would get an independent valuation on their house done every month yet owners of stocks will obsessively check their valuations even more frequently. Indeed, we even have some stock brokers showing realtime valuations.
The ideal behavioural platform would only update stock valuations once per quarter to try to prevent this sort of behaviour.
Investors should entirely ignore short term ups and downs. The valuation that matters is in the distant future when a stock is sold. There is substantial empirical evidence that investors outperform when they check share prices less frequently.
7. Fund managers
Purchasing funds can be a good investment and there is a lot of evidence that the lower the fee the better the performance of the investment.
Most fund supermarkets promote more expensive funds. In the institutional world the equivalent would be hedge funds who have been a huge destructor of investment value.
The behavioural platform should list funds from the cheapest to the most expensive and fees should be lower for investing in cheaper funds and higher to put investors off investing in more expensive funds.
Of course the problem with these seven rules is that they would result in a transfer of wealth from the financial services industry to the investor. It’s therefore highly unlikely that anyone will create a stockbroker following this advice as the profits would all be with the clients.