As much as we try to believe otherwise, the world of investment is not perfectly rational. Research1 by American academics Daniel Kahneman and Amos Tversky 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 recent years in Australian and internationally. Loss aversion is just one of a number of ‘hard-wired’ psychological biases that behavioural finance experts have identified in investors. Some of the others include:
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 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 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”.
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.
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”.
1. Prospect Theory: an analysis of decisions under risk, March 1979.
This publication has been prepared and issued by BT Financial Group Limited ACN 002916458. While the information contained in this document has been prepared with all reasonable care no responsibility or liability is accepted for any errors or omissions or misstatement however caused. All forecasts and estimates are based on certain assumptions which may change. If those assumptions change, our forecasts and estimates may also change.