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Fickle Investors Not So Rational!

by Financial Keys

What type of investor are you? Are you as rational as you think you are? When it comes to investments we often behave quite strangely and to our own detriment. The field of study that focuses on this important area is behavioural finance and understanding the basics might just help you to avoid some classic traps.

Are Investors Rational?

A lot of investment theory is founded in the belief that investors are rational and absorb all existing information and this is then reflected in fair market prices. That the market is efficient and that attempts to outsmart the market just don’t work. This view is the foundation of the Efficient Market Hypothesis and the basis for index investing, a topic on which we have previously commented.

Recent research suggests that investors are not rational and make decisions that are influenced by behavioural biases with their actions more often affected by emotions. Investors who have experienced market downturns are likely to acknowledge that while financial markets are inherently cyclical; these cycles are often exacerbated by investor emotions.

In this article we examine some of the common investor biases. Perhaps you can recognise a little bit of yourself in some of these examples.

Regret Theory

This theory deals with the emotional reaction people experience after realizing they've made an error in judgment.

They are reluctant to admit they have made a mistake such as picking a bad or poorly priced share and they attempt to avoid facing the reality of poor decisions often by holding on to investments too long which can increase their losses.

This feeling is often mitigated where the investor has made a poor decision that everyone else has made. If they are buying shares that are popular then they are less likely to feel regret. Consequently they seek to avoid regret by following the herd and buying shares that everyone else is buying.

Rivalry

The element of rivalry can have a strong influence on investor decisions. This is where the value of gains or the pain attributed by losses is affected by how we perceive our competitors are doing.

“I know I have lost money but as long as I have done better than my cousin then I don’t feel so bad” or “I can make money from a bank term deposit but everyone else seems to be getting a better rate from some of these higher risk companies I see advertised in the paper. I don’t want to miss out.”

Anchoring

Anchoring is where investors use a single piece of information as the basis of all analysis about the value of that investment. An example is the price they purchased an investment for. They see this as the right price and future decisions are based around this. “I’ll hold this investment until I get my money back”.

Anchoring often blinds investors to other important information. For example where circumstances affecting the company have changed or where they paid too much in the first place. This can blind investors to the possibility that there may be better places now to allocate their funds.

Overconfidence

The over confident investor tends to have too much confidence in their own abilities. They regard themselves as above average and are often too quick to attribute investment successes to their skills rather than to market trends.

They are particularly vulnerable in boom markets which tend to re-enforce their belief, leaving them poorly prepared for market corrections.

The overconfident investor believes they can successfully time the market when in reality evidence clearly shows this is near impossible to do. They tend to make decisions without adequate advice or research, which can threaten their long-term strategy. In addition they often participate in an excess number of buys and sells which erodes investment performance.

Mental Accounting - Compartmentalisation

Compartmentalising our thinking can lead to decisions that are not always rational. Take the situation where you may be getting irate with a taxi driver in Mexico over 20 peso fare when he quoted 15 pesos. When you think that you’re getting stressed over 50c an amount less than your usual tip back in Australia it doesn’t make much sense.

Another example is the doctor who attended a conference in the US at a time when the US dollar was at an all time high. All the prices were expensive but the doctor took comfort from the fact that he had received a fee for a talk he gave at the conference that easily covered the cost of the trip. Had he received the same fee for the talk a week earlier in Australia he would not have been so comforted about the high US dollar.

This type of thinking can also affect our investment decisions. For example where we have purchased an investment for $10,000 and after 2 years it had doubled to $20,000. In the next 3 months it fell to $13,000. A 30% gain over 2 years is still a good return but we feel let down because of where the investment had risen to and may be reluctant to sell it until it recovers it’s former highs, even though there may be better places for us to invest that money now.

Loss-Aversion Theory

People fear loss more than they value gain, even if the value of the loss or gain is the same.

Loss aversion theory explains why investors hold onto losing stocks: people often take more risks to avoid losses than to realize gains. For this reason, investors willingly remain in a risky stock position, hoping the price will bounce back. Gamblers on a losing streak will behave in a similar fashion, doubling up bets in a bid to recoup what's already been lost. 

So, despite our rational desire to get a return for the risks we take, we tend to value something we own higher than the price we'd normally be prepared to pay for it.

Over/Under-Reacting

Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic amid downturns. They tend to over or under react to market events which results in prices falling too much on bad news and rising too much on good news.

This type of behaviour causes stocks prices to go way beyond their fair value in times of optimism and way below their fair value in times of pessimism, resulting in asset bubbles and crashes.

Conclusion

People are imperfect processors of information and are subject to bias, error and perceptual illusions. Even the canniest of investors can be caught out by the unpredictability of human behaviour. So what can you do to navigate through these traps?

  • Be aware. Understanding some of these behavioural biases can help you avoid the obvious.

  • Question your decisions. Are you making a choice based on emotion or informed financial analysis?

  • Stay informed. Read the financial press to keep abreast of what is happening.

  • Maintain a well-diversified portfolio. Diversification can assist in avoiding investment biases by helping you to see your portfolio as a whole, and part of a long term strategy.

  • Seek advice. Professional financial advice can help keep your emotional biases in check offering a balanced perspective based on reasoning and research. 

 

July 22, 2015
 
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