18th February 2010
The descent of rational man
In this two-part Investment News, we will consider the emotional factors that can influence our investment decisions and how we can protect ourselves against them.
The evolution of the rational investor
Throughout last year, much was written about the 150th anniversary of the publication of Charles Darwin's most famous work, The Origin of the Species. However, in economic and investment circles, still reeling from the global financial crisis, the magnifying glass was instead being taken to the work of one of Darwin's contemporaries, John Stuart Mill.
Mill was perhaps the most influential English intellectual in the Victorian era. In writing about economics, Mill argued that it should always be assumed that a person inevitably acts to gain the maximum amount of wealth ("necessaries, conveniences and luxuries") with the minimum amount of effort. Commentators on Mill described such a person as 'homo economicus' or 'economic man'. Such a person was assumed to act always in their own self interest and on a rational basis.
Mills' argument was not new. To greater and lesser extents, similar assumptions had been made by earlier economists like Adam Smith and David Ricardo. However, through the nineteenth and twentieth century many economists began to extrapolate these assumptions into complex mathematical models. Over time, 'economic man' became known as the 'rational man' and, with the advent of modern portfolio theory, the 'rational investor'.
The endangered rational investor
At first glance, the rational investor assumption seems reasonable, even if the rational investor would not be your first choice as a guest for your dinner party. After all, investors do tend to act in their own self interest. The rational investor assumption only goes wrong when it becomes an absolute and unvarying law, and adds the amusingly irrational assumption that investors will always act rationally.
When considered on this basis, a moment's thought is sufficient to show the weakness of the theory. If markets always acted rationally, there would be no stock market bubbles, no sub-prime disaster and no Global Financial Crisis. Clearly, in these cases, something is causing 'collective irrationality'.
Survival of the intelligent investor
It is not just whole markets that sometimes lack rationality. Much research has been done showing that the average returns of private investors do not match market returns. When these results are reviewed in more depth, it appears that individual investors are often the victims of behavioural factors. These factors appear to be very common amongst all investors and have been studied in the rapidly growing field of 'Behavioural Finance'.
The clear message from Behavioural Finance research is that all investors are affected by behavioural biases. These biases frequently, negatively, influence returns. The intelligent investor realises that the first step to avoiding investment mistakes based on these biases is to understand the biases and how they work. This week we will consider two of the six most common biases and how you can evolve your investment strategy to protect against them.
Bias 1 - Selective perception
We all like to believe that we consider things in an unbiased way. However, the reality is that we will often selectively perceive what we want to see. There are a number of ways that this can affect our investments. For example, we will place more trust in information coming from people we like. Further, once we form a view on a particular investment option (negative or positive), we will tend to retain that view, even if the underlying investment becomes more or less attractive. Thus, we can be 'emotionally committed' to an investment, even if it underperforms.
The most effective way to protect against this bias is to form objective criteria on which to make investment decisions. These criteria should be based on technical or fundamental analysis, rather than information from one source. These criteria should also be applied (from the very outset) to exit decisions. In nearly all cases, at some point we will be looking to exit an investment. The circumstances of our exit should be determined at the outset, to remove the prospect of our decision being affected by other factors (such as emotional commitment). For example, if investing in the often-volatile stock market, some investors employ a 'stop loss' mark which triggers an automatic sale if a price falls beneath a pre-set amount.
Bias 2 - Group dynamics
Much research suggests that well-organised groups make more accurate decisions than individuals. However, groups also give rise to investment fashions and 'groupthink'. The recent sub-prime crisis revealed many examples of extremely intelligent investors and institutions blindly 'following the herd' to investment oblivion. Individual investors always need to consider the fundamentals of their investment based on their own particular circumstances. Following the herd only increases the chances that you will invest in unsuitable assets.
Awareness is the key to protecting yourself against the risks inherent in group dynamics. Every investment decision should be made based on consideration of your existing portfolio, risk tolerance and investment approach. Whilst advantage can be taken of the strengths of group decision making, be extremely wary of people who are investing in something because 'everyone is doing it'. Further, if you are involved in any group decision making, watch for warning signs of groupthink, such as intolerance of scepticism. It is always worthwhile to surround yourself with people who will challenge your ideas.
In next week's Investment News we will consider the remaining four most common behavioural biases and how you can protect your investment decisions against them.
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Head of Funds Management
t +61 3 8610 2811
Chris Andrews is the Head of Funds Management for the La Trobe Group and has responsibility for the La Trobe Australian Mortgage Fund.
Read full profile here.
La Trobe is one of Australia's leading independent specialist mortgage Financiers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Mortgage Funds under AFSL 222213. It employs over 115 staff and has raised over AUD$10Billion to assist over 100,000 customers since inception in 1952.
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