Financial markets: Calm seas never made a skilled a sailor

By David Fyfe, Portfolio Management for the Mint New Zealand SRI Equity Fund

One of the earliest lessons that shaped my understanding of financial concepts came from my grandfather. He inherited a sizable fortune from a family farm in the South Island, worth over ten times the value of my parents' first house at that time. However, without any financial advice and limited financial know-how, he kept it all in a bank account. Decades later, by the time he passed away, my father inherited a far smaller amount, equivalent to less than a quarter of the value of the same house. The simple but painful lesson here for me was of course that he hadn't taken advantage of the great power of compounding returns, or as Einstein famously called it, the eighth wonder of the world. This realisation sparked my interest in financial markets in respect of generating returns and maintaining wealth, driving me to ensure that such opportunities are not missed.
By the time I had worked my way through to university, I was interested in everything numerical – from economics, accounting, finance, statistics through to my final major in Operations Research. This subject is a discipline that deals with the development and application of analytical methods to improve decision-making. This led me to my first interaction with the fascinating world of behavioural finance.

When I first stumbled upon the works of Daniel Kahneman and Amos Tversky during my early university years, I had no idea that their insights would nudge my career path towards investment management. Their groundbreaking, and at the time somewhat unconventional, research on behavioural economics opened my eyes to the hidden forces driving our financial decisions, forces that traditional economic theories and textbooks often overlook.

One of my early lessons from Kahneman and Tversky was about cognitive biases, particularly the availability heuristic. This concept determines that we judge the likelihood of events based on how easily examples come to mind. Think about it: after a highly publicized shark attack, everyone suddenly becomes wary of swimming, even if statistically, the chances are incredibly low. In the financial world, a recent market crash can leave investors anxious, leading to decisions driven by fear rather than logic. You only need to look to many economic forecasts made, which often just reflect current conditions. Understanding this bias has been crucial in helping me navigate uncertainty and volatility to help make more balanced investment choices.

Another gem from their research is prospect theory, which describes how we perceive gains and losses asymmetrically. We feel the pain of a loss much more acutely than the pleasure of a gain. Picture yourself on a deep-sea fishing trip: catching a small fish feels rewarding, but losing your prized catch at the last moment is heartbreaking. In markets, this means investors often hold onto losing stocks too long, hoping to break even, or sell winning stocks too quickly to 'lock in' gains. By recognizing this behaviour, I have developed strategies that help mitigate these knee-jerk reactions, encouraging a more disciplined approach to investing, especially on buy/sell decisions.