In this series of posts we are looking at how understanding behavioural finance can help you make better investment decisions. In this post we'll look at some of the most common mistakes investors make and how to avoid them.
This information is taken from our free report Beyond Greed and Fear, to download a copy please just click here.
Anchoring
In our last post we introduced the concept of anchoring. One anchoring behaviour that presents itself amongst investors is a reluctance to part with poorly performing investments. Often investors will cling to an investment, waiting for it to break even and get back to the price they paid for it. To avoid this happening, 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 focus too closely on their investment performance. For example, if their portfolio has gone from £100,000 to £120,000 over the past year, they are happy. However, if during that twelve months their portfolio 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
Framing
People’s personality traits can hugely affect the way they react to the actual performance of their portfolio in the future. Consider a situation where two investors (Bob and Brian) have made the same investment. Over one year, the market average rises 10% but the individual investment value increases by 6%.
Bob cares only about the investment return and frames this as a gain of 6%. Brian is concerned with how the investment performs compared to the benchmark of the market average. The investment has lagged behind the market’s performance and Brian frames this as a loss of 4%. Which investor is likely to be happier with the performance of their investment? Because individuals feel losses much more strongly than the pleasure of making a gain, Bob is much more likely to be happy with the investment than Brian.
Their differing reactions here will frame their future investment decisions. Another problem for investors is the strong tendency for individuals to frame their investments too narrowly – looking at performance over short time periods, even when their investment horizon is long-term. People also struggle to consider their portfolio as a whole, focusing too narrowly on the performance of individual components.
70% rule
Consider the 70% rule that advises people to plan on spending about 70% of their current income during their retirement. For most people, this rule of thumb is instantly appealing, which could explain why it has become so popular among financial planners.
Now let’s reframe the 70% rule as the 30% rule and see what happens. That is, rather than focusing on the 70% of expenditure someone would keep through retirement, let’s consider the 30% of expenditure that should be removed. Most people find the 30% rule difficult to digest, even though the 70% and 30% rules are mathematically identical.
Investors hate losses
According to Hersh Shefrin, people feel losses much more strongly than the pleasure of making a gain. This emotional strain is magnified when you assume responsibility for the loss. This guilt feeling then produces an avoidance to risk. But this level of guilt can be changed depending on how a financial decision is framed.
Myopic thinking
Do you focus too much attention on the short-term volatility of your portfolio? While it is not uncommon for an average stock or fund to change a few percentage points in a very short period of time, a myopic (i.e. shortsighted) investor may not react too favourably to the downside changes. This is a recipe for disaster if your goal is to achieve attractive returns over the long term.
Over-monitoring performance
How frequently you monitor your portfolio’s performance can slant your understanding of it. Suppose you were investing over a 5 year period in higher risk funds.
The table demonstrates how you would judge the portfolio depending on the monitoring period. Over the 5 year time frame, equity performance has been positive 90% of the time, and so risky investments do not lose money more than 10% of the time. However, if you were to monitor the performance of the same portfolio on a month-by-month basis, you would notice a loss 38% of the time!1
Once again, because of our in-built dislike to loss, monitoring your portfolio more frequently will cause you to see more periods of loss, making you more likely to feel emotional stress and take less risk than is suitable for your long-term investment objectives.
1 Kahneman and Riepe, 1998.Hindsight bias
Many events seem obvious in hindsight. Hindsight bias tends to occur in situations where a person believes (after the fact) that the beginning of some past event was predictable and completely obvious, whereas in fact, the event could not have been reasonably predicted. Psychologists connect hindsight bias to our inborn need to find order in the world by creating explanations that allow us to believe that events are predictable.
For example, many people now claim that signs of the technology bubble of the late 1990s and early 2000s (or any bubble in history, such as the Tulip bubble in the 1630s or the South Sea bubble of 1711) were obvious. This is a clear example of hindsight bias: if the creation of a bubble had been obvious at the time, it probably wouldn't have escalated and eventually burst.
Blame the adviser
Another example of hindsight bias is when an investor blames their adviser for choosing the worst performing fund in their portfolio. The investor suffering from hindsight bias will say things to their adviser like, ‘Why did you recommend this underperforming fund?’
What the investor is unfortunately forgetting is that in a portfolio, there are always going to be winners and there are always going to be losers. The investor is failing to look at the bigger picture of the ‘total performance’ of their portfolio and see that it wasn’t so obvious that the fund in question was going to turn out to be a poor performer.
Herd behaviour
One of the most shocking financial events in recent memory was the bursting of the Internet bubble. However, this wasn’t the first time that something like this had happened in the markets. But how could something so harmful be allowed to happen over and over again? The answer to this question can be found in what some people believe to be a hardwired human quality: herd behaviour, which is the tendency for individuals to copy the actions (rational or irrational) of a larger group.
Individually, however, most people would not necessarily make the same choice. While it's tempting to follow the newest investment trends, you are generally better off steering clear of the herd. Just because everyone is jumping on a certain investment bandwagon it doesn't necessarily mean that the strategy is correct.
In our next post in this series we'll look at the problems caused by overconfidence.
This information is taken from our free report Beyond Greed and Fear, to download a copy please just click here.
As always, if you have any questions or thoughts on the points covered in this post, please leave a comment below or connect with us @ISACO_ on Twitter.
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2 Internal estimation taken January 1st 2015 of total ISA and pension assets owned by the ISACO Investment Team and ISACO premium clients.3 December 31st 1997 - December 31st 2014 ISACO 105.5%, FTSE 100 27.6%.
4 December 31st 2011 – December 31st 2014.
ISACO investment performance verified by Independent Executives Ltd.
