The Irrational Investor: According to Behavioral Finance

The investor’s chief problem—and even his worst enemy—is likely to be himself. – Benjamin Graham

The all too familiar experience of investing: a “roller coaster of emotions”.

First you spot a trend, you start to watch, prices are high and you start to buy. Then you sell and then you cry. But wait, is this legal? Oh, I’m glad I sold. And then in the end: why didn’t I hold.

This is the short version, but nevertheless, you are not alone. After all, the cyclical investment process, which includes information procurement, stock picking, holding, and selling investments, followed by making a new selection, is full of psychological pitfalls. However, only by becoming aware of and actively avoiding behavioral biases can investors reach impartial decisions. The emerging field of behavioral finance aims to shed light on true financial behavior.

We all have strongly-ingrained biases that exist deep within our psyche. While they can serve us well in our day-to-day lives, they can have the opposite effect with investing. Investing behavioural biases encompass both cognitive and emotional biases. While cognitive bias stem from statistical, information processing, or memory errors, an emotional bias stems from impulse or intuition and results in action based on feelings instead of facts.

Humans tend to be positive creatures, and thus making room for the emotional bias of overconfidence. Overconfident investors believe they have more control over their investments than they truly do. Since investing involves complex forecasts of the future, overconfident investors may overestimate their abilities to identify successful investments. 

Loss Aversion Bias: Established financial efficient market theory holds that there is a direct relationship and trade-off between risk and return. The higher the risk associated with an investment, the greater the return. The theory assumes that investors seek the highest return for the level of risk they are willing and able to take on. Behavioural finance disagrees. In a study by behavioural finance pioneers, Dan Kahneman and Amos Taversky found that investors are more sensitive to loss than to risk and possible return. In short, people prefer to avoid loss over acquiring an equivalent gain: It’s better not to lose R100 than to find R100.  Some estimates suggest people weigh losses more than twice as heavily as potential gains. Even though the likelihood of a costly event may be miniscule, people would rather agree to a smaller, sure loss than risk a large expense.

Information Bias is the tendency to evaluate information even when it is useless in understanding a problem or issue. In general, investors would make superior investment decisions if they ignored daily share-price movements and focused on the medium-term prospects for the underlying investment and looked at the price in comparison to those prospects. By ignoring daily commentary regarding share prices, investors would overcome a dangerous source of information bias in the investment decision-making process.

Confirmation Bias is the tendency to seek information or interpret information in a manner that supports pre-established views on a decision or topic. If someone believes that a specific oil company is a great investment, they have a tendency to only seek out information that supports this belief and discredit information that offers a conflicting view.

Anchoring speaks to the tendency people have to use their own experiences to shape future judgement. In the Psychology of Money, Morgan Housel explains anchoring by saying “Your personal experiences make up maybe 0.0000001% of what’s happened in the world but maybe 80% of how you think the world works”. When it comes to investing, people can become anchored on a recent piece of news that they’ve heard, or a story told to them by their neighbour about the latest hot stock.

Trend-chasing Bias: Investors often chase past performance in the mistaken belief that historical returns predict future investment performance. This tendency is complicated by the fact that some product issuers may increase advertising when past performance is high to attract new investors. Research demonstrates, however, that investors do not benefit because performance usually fails to persist in the future.

The most important aspect of behavioural finance is peace of mind. By having a thorough understanding of your risk appetite, the purpose of each investment in your portfolio and the implementation plan of your strategy, it allows you to feel much more confident about your investment plan and be less likely to make common behavioural mistakes.

Working with a financial planner can help investors recognize and understand their own individual behavioural biases and predispositions, and thus be able to avoid making investment decisions based entirely on those biases.

By Petri Beyers

Post a comment

Your email address will not be published. Required fields are marked *