18th March 2010

Dear Investor,

The Descent of Rational Man Part II

In this edition of Investment News, we return to our discussion of the emotional and behavioural factors that can influence our investment decisions and how we can protect ourselves against them.

The evolution of the rational investor

In our earlier edition of Investment News, we discussed how the rapidly growing field of behavioural finance is increasing our understanding of markets and investment decisions. We learned that all investors are affected by behavioural biases, which 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.

The two biases we considered in our earlier edition of Investment News were:

  1. Selective perception: the process by which we all subconsciously see what we are predisposed to see, rather than objective reality. To guard against this, we should make investment (and exit) decisions based on technical or fundamental analysis, backed by objective criteria.
  2. Group dynamics: the process by which 'following the herd' and 'groupthink' leads individual investors to follow the market to investment oblivion. Again, to guard against this difficulty, we must cultivate scepticism and watch for any signs of groupthink. Surrounding ourselves with people who will challenge our ideas is a useful, if sometimes uncomfortable, strategy.

In this week's Investment News, we will consider the remaining four most common behavioural biases and how you can protect your investment decisions against them.

Bias 3 - Losses and gains

At the heart of this bias lies the Nobel Prize winning insight that investors fear losses more than we value gains. As a result, many investors delay exiting an investment at a loss or do so only very reluctantly. By contrast, when we invest in an asset that increases in value, we frequently want to take the profits to validate our investment decision (and, of course, to avoid the risk that we will subsequently be forced to exit the investment for a lesser value).

There are a number of strategies that can be utilised to address this bias. First, investors should take care not to review our portfolios too frequently. Although this appears counter-intuitive, the findings of behavioural finance suggest that over-frequent reviews highlight short-term market fluctuations. This can lead investors to lose sight of their overall goals.

Second, 'stop loss' marks should be set at the time of investment, so that investors have objective and concrete criteria to determine when an investment should be sold. This can help investors avoid clinging to losing investments for too long.

Finally, investors can manage our loss-aversion by investing in products with some form of capital protection.

Bias 4 - The fun of speculative investment

Although investors are generally very loss averse, this conservatism seems to change dramatically when we are presented with risky investments promising high returns at low investment cost. The popularity of lotteries is a good example of this bias in action. Neurological studies show that risky investments can often trigger 'reward' parts of the brain, regardless of the investment results. In other words, for many investors, risky investments are fun!

The intelligent investor can protect against this bias first and foremost by recognising it. Once recognised, it can be managed and channelled. One way to do this is for investors to invest a specific and pre-determined amount of our wealth in speculative investments. The rest of the portfolio can be devoted to less risky options. Further, high risk investments often incur losses, so investors need to be careful not to 'throw good money after bad.' When 'stop-loss' thresholds are triggered, we must be disciplined and exit the investment. Finally, all speculative investments should still be made based on a solid investment case, rather than hunches and intuition.

Bias 5 - Decision making rules

One advantage that the human brain has over computers is the use of heuristics or 'rules of thumb' to make speedy decisions amidst uncertainty. Although extremely useful, these heuristics are also prone to error. There are many examples that can be used to illustrate this:

  • Studies show that our memories do not 'store' events, but reconstruct them on the spot, filling in missing details based on relevant information. Further, we have a tendency to forget negative experiences faster than positive ones and have a 'hindsight bias' that convinces us in retrospective that we 'knew it all along'.
  • We often assess probabilities of events based on how closely it represents a scenario that we already have in our minds. Thus, for example, if a tossed coin produces tails three times consecutively, most people assume that it will next land on heads, even though another 'tails' result is equally likely.
  • The more frequently an event has occurred to us personally, the easier it is for us to imagine that it will happen again. We therefore project our own past experience into the future.
  • From an economic point of view, it does not matter how much money (or time) we have invested into something. The only relevant factor is future costs and benefits. However, we are frequently reluctant to abandon something into which we have poured money or effort and such decisions are often the most difficult for investors.

The key way to protect against these decision making biases is to impose the discipline of rational thinking on all of our investment decisions. We should keep accurate records of key information, not rely overly on our own inclinations and subjective experiences, not assume that chance will be self-correcting and be honest when we attribute success and failure.

Bias 6 - Our mental accountant playing tricks

Like any business, investors invariably have our own accountant and accounting practices in our heads. This can manifest in a number of ways. For example:

  • When considering the purchase of a product (such as an investment), we do not just consider how useful or beneficial the product will be in itself, we are also influenced by how a good a deal we believe that we are getting. In effect, we are setting a personal 'reference point'. When applied to investing the dangers are obvious. We can frequently make an investment because our personal reference point is higher than the offer price (perhaps because our friends and neighbours have already invested) rather than the intrinsic merits of the investment.
  • Multiple, smaller gains provide more pleasure than a single, large gain. Similarly, multiple small losses hurt more than a single, large loss. This contributes to investors taking profits too soon and holding losing investments for too long.

This bias can be managed by adopting a number of strategies:

  • ensuring that investment decisions are based on a fair and objective price, rather than our own internal reference points; and
  • viewing all investments as part of a portfolio, rather than breaking them down individually.

Conclusions

As can be seen, there is a lot more going on when an investment decision is made than the 'rational investor' assumption would have us believe. But by understanding the psychological factors influencing all of our decisions, investors can control for them and ensure that our decisions are truly intelligent. And that is progress.


Best regards,
Chris Andrews

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Chris Andrews
Head of Funds Management

t  +61 3 8610 2811
e  candrews@latrobefinancial.com.au

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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