Psychology in Investing

Article #10 by Adrian Gafà - Published Monthly

When Warren Buffet’s right-hand man, Charlie Munger was asked for a single word to account for his remarkable success in investments, he simply replied that ‘he was rational’. Traditional financial theory assumes that all investors are rational and apply all the information that is available at the time when undertaking an economic decision. However, this notion has been challenged by Behavioural Finance Theory which attempts to explain the emotional and psychological factors that lead to irrational investment decisions.

In fact, in practice, investors constantly exhibit irrational behaviour which may lead to sub-optimal investment decisions. Behavioural Finance attempts to identify different, but highly correlated, behavioural biases as well as aiding investors in overcoming such limitations in financial decision-making. Understanding, and possibly overcoming, these biases is therefore imperative to improve the effectiveness of your investment decisions and in attaining the desired financial objective.

Although various behavioural biases have been identified in numerous studies, the different biases are highly correlated and in reality, difficult to separate one from the other. Nonetheless, in theory, behavioural biases are defined under two broad categories, ‘cognitive errors’ and ‘emotional biases’. Cognitive errors are related to the limitations of the human brain in processing all of the information available. These type of behavioural biases can be recognized and their effects can be reduced or even eliminated in some instances.

On the other-hand, emotional biases relate to an individual’s temperament, spontaneity or moods as they play a part in deviating decisions from their logical alternative. These type of biases are often very difficult to keep under constant control.

The following paragraphs will outline some of the most common psychological biases, their consequences and what can be done to overcome them.

One category of cognitive biases is called ‘Belief Perseverance’ and include biases such as conservatism, confirmation, and hindsight. Such biases indicate investors’ unwillingness to incorporate new information and continue to hold their previously held views irrespective of any developments. This is especially true when the information is contradictory to the existing belief. In such instances, investors, at least as a first reaction, tend to downplay contradictory information as noise. Furthermore, people tend to hold on to past outcomes and as time progresses tend to believe that they had accurately forecasted those outcomes.

For example, one might logically conclude that General Electric is a great company because it has stood the test of time (established more than 120 years ago) and became the international conglomerate we know today. Unfortunately, GE has recently been experiencing rather severe disruptions in its business model as it was subject to an investigation on its accounting practices, suffered losses on certain lines of business and also faced cash flow challenges, amongst others. Nonetheless, given the group’s heritage, an investor may shrug off such disruptive news and continue to simply reiterate that GE is a great company and will overcome such challenges without an appropriate analysis.

The other category of cognitive biases is referred to as ‘information-processing’ biases, including anchoring, mental accounting and framing. These relate to how investors process information that is used to form an investment decision. Various studies have concluded that the human brain has a number of limitations in processing information which more often than not lead to illogical or irrational decisions.

Meanwhile, one type of emotional bias is loss aversion whereby the effect (financial pain) of a loss is greater than the satisfaction brought about by a profit. In turn, this leads to the disposition effect whereby investors tend to hold on to a loss-making investment in the hope that someday the investment will be recovered in full without giving undue importance to the underlying fundamentals of that same investment. Loss aversion may also lead an investor to sell profitable investments (forgoing further growth potential) to simply avoid facing losses that may materialise in the future.

Change is difficult to embrace for humans in every aspect of life. This is also the case in investments. In fact, investors tend to exhibit the status-quo bias whereby they tend to hold on to their existing holdings and avoid the responsibility of taking a decision. This bias is also highly linked to the regret aversion bias which further explains investors’ wish to avoid future regrets in the event that their investment decision does not go as planned.

Another type of emotional bias is the endowment bias. In this respect, investors tend to attribute a value to owned investments which is much higher than the price they would be willing to pay to acquire the same security, at the same point in time and under the same circumstances. This bias is especially evident when dealing with inherited assets as investors tend to attach a sentimental value to that particular security thereby raising its value without any economic rationale.

The consequences of behavioural biases can vary but the most common outcome is likely to be inappropriate diversification across asset classes, sectors, regions and currencies, amongst others. Furthermore, investors might expose themselves to excessive risk as they take irrational decisions. For example, the loss aversion bias may limit an investor’s upside potential (by cashing in any profitable positions) but remain exposed to downside risk by holding on to loss-making positions in the hope they rebound and at least break-even.

Biases may also lead an investor to have a false sense of confidence in the portfolio of investments held as this may be based on outdated information. Additionally, when reviewing or appraising the performance of such a portfolio, the conclusion might also be inaccurate given these behavioural biases including hindsight.

Although not all investments will be successful, hence the need for optimal diversification, investment decisions flawed by behavioural biases could easily preclude an investor from reaching his/her investment objectives. Such failure could lead the investor to either abandon investments completely or to exhibit herding. In the latter case, an investor would start following what others are doing which is a very risky stance since investment portfolios should be tailored to match the financial situation and objectives of each and every investor.

Being aware of the various behavioural biases and their respective consequences is the first step in overcoming these same biases. In general, investors should keep themselves informed about any new developments whilst giving due consideration to unfolding developments. Furthermore, at the outset, investors must set rules (including investment objectives and risk parameters) for their portfolios as well as individual investments that will guide them in undertaking investment decisions whilst reducing the amount of emotional influence on such decisions.

Finally, investors should seek ongoing professional assistance with their trusted financial intermediary. The advisory or discretionary portfolio management services offered by financial services practitioners should enable an investor to appropriately construct and maintain a diversified portfolio in line with the investor’s objectives and risk parameters.

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