In the second of our series of posts on behavioural finance, we'll look at two anomalies that can cause investors to behave in a less than rational way. It's worth considering whether you've ever fallen prey to either of these biases. Chances are, at one point or another, we all have.
Anomalies in the stock market
Despite strong evidence that the stock market is highly efficient, there have been scores of studies that have documented long-term historical anomalies, or irregularities, in the stock market that seem to contradict the efficient market hypothesis, which assumes rational and logical behavior.
While the existence of anomalies is generally well accepted, the question of whether investors can exploit them to earn superior returns in the future is subject to debate. Investors evaluating anomalies should keep in mind that although they have existed historically, there is no guarantee they will persist in the future.
In this post, we'll look at two such anomalies, the winner's curse and anchoring.
The winner's curse
One assumption found in finance and economics is that investors and traders are rational enough to be aware of the true value of an asset and will bid or pay accordingly. However, anomalies such as the winner's curse – or the tendency for the winning bid in an auction to exceed the intrinsic value of the item purchased – suggest that this is not the case.
Rational-based theories assume that all participants involved in a bidding process will have access to all relevant information and will all come to the same valuation. Any differences in the pricing would suggest that some other factor not directly tied to the asset is affecting the bidding.
According to Robert Thaler's 1988 article on the winner's curse, there are two primary factors that undermine the rational bidding process: the number of bidders and the aggressiveness of bidding. For example, the more bidders involved in the process, the more aggressively you may have to bid in order to dissuade others from bidding.
Unfortunately, increasing your aggressiveness will also increase the likelihood of your winning bid exceeding the value of the asset.
The concept of anchoring
Similar to how a house should be built upon a good, solid foundation, our ideas and opinions should also be based on relevant and correct facts in order to be considered valid. However, this isn't always so.
Anchoring is one of the root psychological flaws that pushes otherwise brilliant people to make financial mistakes. It causes individuals to cling to a belief that may or may not be true, and to base their decisions for the future on that belief.
The ‘inertia’ that this leads to can have detrimental effects on their investment accounts. For instance if people anchor themselves to the idea that the stock market will keep going up, they will not only suffer from inertia, but will inevitably find themselves in a risk category that isn’t the right fit for them and they’ll be putting themselves at a far greater risk when that market turns.
Consider this classic example taken from investopedia.com. Conventional wisdom states that a diamond engagement ring should cost around two month's salary. This ‘standard’ is a wonderful example of anchoring and illustrates why most of us make illogical and irrational financial decisions. While spending two month's salary can serve as a benchmark, it is a completely irrelevant reference point created by the jewelry industry to maximise profits and not a valuation of love.
Many men can't afford to devote two month's salary towards an engagement ring while still paying for living expenses. Consequently, many go into debt in order to meet the ‘standard’. In many cases, the ‘diamond anchor’ will live up to its name, as the prospective groom struggles to keep his head above water in a sea of mounting debt. Although the amount spent on an engagement ring should be dictated by what a person can afford, many men illogically anchor their decision to the two-month standard. Because buying jewelry is a 'novel' experience for many men, they are more likely to purchase something that is around the ‘standard’, despite the expense. This is the power of anchoring.
The implications for investors
While the winner's curse could cause investors to overpay for an asset, anchoring can lead to an unwillingness to part with laggard investments. Often investors will cling to an investment, waiting for it to ‘break even' by getting back to the value they paid for it.
Some behavioural finance experts recommend you ask yourself: Would I buy this investment again? And if you wouldn't, why are you continuing to own it?
Another example is when investors fixate on relative past performance. If their portfolio has gone from £100,000 to £120,000 over the past year, they are happy. However if their portfolios rose to £150,000 before dropping back to £120,000, they are upset. People mistakenly anchor to the high-water mark of their portfolios and are only satisfied when they hit an all-time high.
In the next post in this series, we'll explore another key concept of behavioral finance known as 'framing' and the detrimental affect it can have on investors' decision making.
I hope you've found this post useful. As always, if you have any questions or thoughts on the points I've covered, please leave a comment below or connect with us @ISACO_ on Twitter.
Please note past performance should not be used as a guide to future performance, which is not guaranteed. Investing in Funds should be considered a long-term investment. The value of the investment can go down as well as up and there is no guarantee that you will get back the amount you originally invested.
About ISACO
ISACO was established in 2001 by brothers Stephen and Paul Sutherland and is the first financially regulated firm to offer adventurous ISA and SIPP investors a unique personal investment service that shares on a daily basis our star-performing investor’s thoughts, personal insights and investment decisions.
Clients enjoy being informed throughout the year what ‘best of breed’ funds our premier investor currently owns, when he’s buying and when he’s moving into the safe harbour of cash – helping clients enjoy more control, manage their portfolio more effectively and benefit from the potential of outstanding long-term returns.
For more information about ISACO and our Investment Guidance Service, please read our free brochure.
