The descent of rational man
Investor Insights 2 April 2015

A student of financial markets is typically struck by the peculiar ways in which they operate. For example, at the time of writing, the ASX200 has for some time been approaching, but never crossing, the 6,000 mark. Why is this the case?

Some investors try to base their investment decisions on these behavioural peculiarities. They talk of market ‘resistance points’ and look for early indicators that market sentiment is changing (either for the better, or the worse). But this analysis does not normally explain why these peculiarities exist. After all, the fortunes of the companies in the market do not shift as quickly or dramatically as the moves in market sentiment.

In this Investor Insight, we will revisit the issue of behavioural finance and 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 2009, 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 he or she would not be the first choice as a guest for your dinner party. After all, investors do tend (or at least try) 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, and 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 six of the 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.

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.

STOP PRESS – Next Investor FY2015 Q3 Call Briefing scheduled

Date: Thursday, 16 April 2015

Time:

NSW, VIC, TAS, ACT, QLD

12:00pm - 12:30pm  (AEST)
  SA, NT 11:30am - 12:00am  (ACDT)
  WA 10:00am - 10:30am  (AWST)

Where:

Connect via your computer or simply call-in via your phone

Further details will be provided on registration.

Best regards,

Chris Andrews
Chief Investment Officer

     
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