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Nov 1, 2015

Investor, Know Thyself

by David Ensor

David EnsorOur world is full of convenient fictions beloved of much financial regulation— such as the “reasonable man” or “reasonable expectations”—and significant monies are spent in lobbying to avoid brokers and investment advisers having to hold themselves to a tough and unambiguous fiduciary standard of care in advising clients or managing their investments.

Of course, nowadays, when you open an account with a Canadian broker, you will have to go through a lot of rigmarole, form-filling and box-ticking to address the paranoia of that firm’s Compliance Department—ensuring that you are not a drug lord, or a covert member of a terrorist financing cell. And, yes, you are supposed to describe what your tolerance for risk is, but you are kidding yourself if you believe that the firm has your best interests at heart: in reality it is trying to ensure that, if it messes up, it will be very difficult for you, the client, to sue successfully for redress.

Thus, it is never a good idea to assume that you can rely upon anyone else but yourself to protect your own interests. However, first it makes sense to understand the type of investor you are, for without that, you can never really make a proper assessment of how competent you are and the boundaries you should set for yourself in managing your investments, whether directly or indirectly.

In a recent paper, entitled “Reasonable Investor(s)”, Tom Lin, an Associate Professor of Law at Temple University, focussed on how regulation needs reform in many areas to deal with the diversity of investors, both human and non-human. In doing so, he performed a useful service, creating a classification of investor types that regulation needs to address.

So, the question is: which type are you? Do you recognize yourself in any of these descriptions?

1) The Reasonable Investor:

This is the paradigm and the paragon, although whether he or she truly exists is a different matter! This person is supposed to be entirely rational, and fully capable of reading, absorbing, comprehending and applying all the information available in today’s cacophonous and noisy marketplace. Thus, he or she is able to price the risks and rewards of any investment properly.

Interestingly, the assumption is that this individual is a passive, long-term investor of moderate wealth, and, paradoxically therefore needs the protection supposedly afforded by financial regulation.

Frankly, we find this odd because someone who is both rational and reasonably well-informed would also likely be intelligent enough to understand the risks and vagaries to which, as a minority investor, he or she is vulnerable, and take appropriate steps to address this.

2) The Irrational Investor:

This individual is identified primarily as the result of work done in the field of behavioural economics, which recognizes and demonstrates that in reality homo economicus (the rational actor of neoclassical economics) is actually a theoretical construct and does not represent the behaviour of the average human being.

This individual is not able or inclined to try to understand the intricate, absurdly voluminous and often deliberately obscure or misleading financial disclosures of public companies; he or she is easily influenced by “fashion”; and prey to financial scams or fraud; often lacking basic financial literacy.

Such an individual is not dispassionate, but emotional, biased and vulnerable to the consequences of crude heuristics and framing decisions, using limited or inappropriate information and decision factors. He or she probably trades too frequently and for reasons that have nothing to do with a reasoned process—combining optimism and loss aversion.

3) The Active Investor:

Unlike the largely passive Reasonable Investor, the Active Investor does not keep quiet, or simply sell out of a position in frustration, but tries to influence the behaviour of a company’s management. Of course, for most retail level investors, this is far easier said than done (particularly given the shackles that North American corporate governance rules tend to place on the ability of individual shareholders to challenge a company’s direction or management).

However, this paradigm also encompasses the individual who has a shorter investment horizon (including, it would seem, most “professional” investment managers) and focusses on holding periods that may not be measured even in months, or days, but nanoseconds. The focus is not value in the long term, but price movements and discrepancies. At the retail level, this most clearly describes the so-called “day trader”, who bases his or her actions on momentum or noise.

4) The Sophisticated Investor:

In theory, this paradigm describes an individual who possess a superior level of wealth and (supposedly) financial acumen; and, in the US at least, is defined under SEC rules in purely economic terms at thresholds that no longer seem that high (in broad terms, USD 1MM net worth, alone or joint with a spouse; or income above USD 200,000 per annum, or USD 300,000 joint with spouse.)

In the real world, many people who come close to or exceed such definitions could not in any sense be considered “sophisticated” when it comes to investing—which may be a good thing if it makes them skeptical of the blandishments of those only too happy to help them manage their wealth!

There are, of course, individuals who properly fit the natural meaning of the term, because they understand that investing successfully requires patience, reason, a healthy skepticism, and recognizing one’s limitations as well as strengths.

So, Dear Reader, how would you view yourself against each of the above paradigms? Frankly, I would be shocked if, being completely self-aware and honest, you identified with any one individual category. Why? Because you are human and not an algorithmic model. We are all subject to the flaws described in the Irrational Investor paradigm, whether we are willing to acknowledge it or not.

The real danger lies in not being willing to do so. Being self-aware ensures we put in place an investment process that fits our personality, capacity for absorbing risk and risk appetite.

So, Investor, above all else, know thyself!

David Ensor, Risk Management Consultant: