Investor behaviour: that sinking feeling

17/04/2008

The share market shake-up of the past six months has had emotional, as well as financial, consequences. Fortunately, insights from the world of behavioural finance can help us deal with those emotions and improve our investment decisions.

Over the past five years the Australian share market has generated a total return of 129% (as measured by the S&P ASX 300 Accumulation Index to the end of March 2008). But, for the last six months of that period it lost approximately 17%.

In a perfectly rational world, we might look at those two numbers and comfort ourselves with the view that our long-term returns were more than acceptable.Yet much as we try to believe otherwise, the world of investment is not perfectly rational.

Research by Daniel Kahneman and Amos Tversky from the field of what’s referred to as ‘behavioural finance’ suggests that investors feel the pain of a loss much more deeply than the pleasure of an equal gain. This behaviour — known as loss aversion — can have a significant effect on how investors act. It is likely these effects are magnified by major market moves such as those experienced in the past six months in Australia and internationally.

Loss aversion is just one of a number of ‘hard-wired’ psychological biases that behavioural finance experts have identified in investors. Here’s a summary of the others.

  • Money Illusion
    Identified by American economist Irving Fisher, the ‘Money Illusion’ leads investors to believe that monetary factors like prices, rates and currency values are fixed rather than variable. Many investors ignore the effect of inflation on the price of their assets. Others assume the interest rate they borrowed at will remain unchanged.
  • Anchoring
    Anchoring refers to our tendency to see a recent price as the ‘right’ price. An investor who bought a speculative stock at the top of a boom, may have difficulty believing it was overpriced when they bought and prefer to believe the market is now ‘underpricing’ their stock.
  • Regret and the disposition effect
    Regret is closely linked with loss aversion. Research suggests regret has such a strong emotional weight that investors are often reluctant to admit an error — such as buying a ‘poor’ stock. To avoid facing that regret, investors tend to defer selling stocks that have gone down and, as a result, they effectively ‘compound’ their mistake.

    This, in turn, leads to what University of Santa Clara academics, Hersh Shefrin and Meir Statman, called the ‘disposition effect’ — the tendency for investors to hold on to their ‘losing’ investments too long and sell their ‘winners’ too soon.
  • Attribution and overconfidence
    Behavioural finance experts have also identified a tendency for investors to believe that good returns are the results of their investment skill and bad results the result of bad luck. This bias is known as self-attribution.

    Odean and Barber, business school professors at the University of California have pointed out that modern technology may have exacerbated this bias. Thanks to the internet, individual investors have access to vast amounts of information. Professor Odean has explained the consequences, “…when people are asked to make predictions based on information before them, the quality of those predictions doesn’t rise in line with increases in the amount of information they have. But the confidence people have in their predictions goes way up”.
  • Mental accounting
    According to experts such as Richard Thaler, investors are prone to what he calls ‘mental accounting’ — focusing excessively on the gain or loss from each investment decision and not on their total portfolio or overall wealth.

Not logical, but reasonable

Experiencing these investment biases does not mean you are a bad or unintelligent investor. Indeed, as one of the leading lights of behavioural finance Meir Statman has said, “People in standard finance are rational. People in behavioural finance are normal.”

The key is to recognise that your reaction to investment events will be coloured by these biases and that these biases can damage your wealth:

  • ‘Overconfidence’ can lead to excessive trading and excessive trading costs money. In research conducted by Odean and Barber the most active 20% of investors underperformed the least active 20% by 5.5% a year!

  • By succumbing to the ‘disposition effect’, investors typically gave up 3.5% of their potential return.

  • ‘Mental accounting’ means investors can be spooked out of investing by one poor performing stock, despite the fact that their overall position across their portfolio has improved.

Dealing with bias

As recent market events have highlighted, it’s difficult to manage these investment biases in the emotional environment of a falling market. It makes sense to tailor your investment strategies to beat the biases before they cost you money.

Staying unbiased

Investment experts have long promoted the benefits of diversification. One of its underestimated benefits is that a planned approach to diversification helps control some investor biases, particularly ‘overconfidence’.

If your investments are sensibly diversified you’re less likely to ‘fall in love’ with an investment and less likely to over-trade. Sensible diversification can also reduce the tendency towards ‘mental accounting’, as it encourages you to take a portfolio, rather than stock-specific, view.

There are also investment strategies that reduce the ‘disposition effect’. In 2005, BT and the University of Western Australia conducted research into 850,000 managed fund investors covering a 31 year period. It revealed that the combination of advisers and managed funds helps protect investors from the ‘disposition effect’.

Anecdotal evidence suggests that managed funds may ‘distance’ an investor from market sentiment in a way that direct shares do not. As a result, investors may be less prone to overreact to market moves if they invest in the market via a managed fund, rather than in direct equities.

There is also significant research to suggest that advisers add more discipline to individual investor decisions — especially when markets are moving. As one adviser told a BT research panel, “It’s our job to take the knives out of the kitchen”.

More resources and reading

Investing Markets and performance
Economics: Caton's Corner Superannuation