Self sabotage on investments is just a thought away
Think you approach your investments logically? Research shows investors can sabotage their investment strategy based on several types of behaviour, including a ‘herd mentality’ and emotion. Knowing how and why you can sabotage your investment strategy gives you a stronger understanding of how to avoid it.
Markets are not purely efficient beings, driven by rational investor decisions. Perhaps surprisingly, emotion plays a big part - with both fear and greed at the root.
There is actually a field of study, called “behavioural finance theory”, that uses psychology to explain various investment decisions, such as why the most amount of money is invested into the market when it’s near the top, and conversely, the greatest outflows are when the market is near its bottom.
While it’s clear emotions cause investors to act irrationally (and cause situations like that above), it’s not just the individual investors who are affected. Interestingly, those irrational actions have significant – and sometimes long-lasting - effects on market prices and, hence, market efficiency.
Why do investors act irrationally?
Errors in investment timing - too much money in during peaks, too much pulled out in troughs - come back to 3 reasons:
i) investors have no investing strategy or decision-making framework
ii) they have a strategy, but allow their emotions to chip away at it
iii) they react based on limited or short-term data, without understanding all the available information
Surely the ‘herd mentality’ doesn’t come into investing?
Actually it does - even when an investment strategy exists. Investment-timing errors are caused by numerous “behavioural science” - or psychological - issues with the “herd mentality” being just one.
For instance, humans are social creatures, tending to follow what everyone else is doing. With investments, this can see us saying, “ooh, I’d better get in now” when the markets are running hot. It’s interesting to note that type of behaviour can be traced back 300 years!
Greater risks to avoid losses
Research has also shown that investors are willing to take greater risks to avoid losses, than they are to realise gains. When faced with a sure gain, more investors are risk-averse; but when faced with a sure loss, investors become risk-takers.
This is called “prospect theory”, because the behaviour differences are explained by how people feel (so emotions again) about that prospective loss or gain. Time and again, it’s been shown that people are more distressed by prospective losses than they are pleased by the equivalent gains.
Their emotion (pleased or distressed) directly affects how they behave in a situation. And that emotion, hence behaviour, is directly related to whether a situation is presented in the context of a loss or a gain. Even when it’s the equivalent situation, the person’s emotions will dictate different behaviours to perceived losses and perceived gains.
Such reactions come back to merely being human beings. Humans are emotional, and usually can’t prevent emotions from interfering with logic. That’s when shortcuts are taken, and investment strategies skewed.
Psychology explains the housing bubble
Essentially, psychology is the science of human behaviour; markets are driven by human behaviour, so it’s sensible to use psychology to explain the efficiency of financial markets, plus any anomalies, bubbles or crashes.
Our mental biases also affect investing and money-management practices, including:
- valuing some dollars less than others, typically seen on investment profits -”not my money in the first place” -where investors take greater risks than with the capital invested
- avoiding short-term losses at the expense of long-term gains
- throwing good money after bad
- wanting to keep things the way they are
- viewing something you own to be worth more than if you didn’t own it
- avoid any action from the fear it will be a mistake; typically shown as a reluctance to sell stocks that have dived just to avoid the pain and regret of a bad investment
- confusing “real” and “actual” changes in money, such as the impact of inflation on purchasing power
- paying more attention to big numbers than small numbers
- putting more importance on recent events than older ones
- clinging to a fact or figure that really should have no bearing on your decision, this is usually when there’s some uncertainty about answers
More on herd mentality
The herd mentality is another mental bias. It can kick in when you’ve bought a popular stock and then rationalise its decline by saying “everyone else owned it and they thought so highly of it”. A common fallacy is also believing money managers and advisers favour well-known companies because they are less likely to be fired if those companies under-perform (or believing that having conceivably not “stuck their neck out” on lesser-known companies may land them in less hot water).
Herd mentality says that when everybody else seems to be getting rich, an individual feels they’re missing out, so they’d better get in quickly. However, often they’re too late, so the reverse occurs.
Market trading volumes back this up: volumes are higher when markets show positive returns. This is because there’s a big difference between people taking profits and being prepared to take losses. So volumes in bull and bear markets are different.
Overestimating your own abilities is gender based
It’s not quite the whose-the-better-driver issue, but overestimating your own abilities is another mental bias some investors hold.
Comparing the trading activity and average returns of men and women throws up some interesting stats:
i) men (particularly single men) trade far more actively than women
ii) more frequent trading often means poor investment performance
iii) women tend to be more risk averse than men
Passive investors typically became wealthy without much risk, while active investors have typically become wealthy earning money through their own labour.
Considering that over-confidence leads to greater trading, and greater trading generally leads to poorer returns, women are generally better investors than men - just because of that.
Don’t look just yet
One problem that can lead you to skew your investment strategy is the large industry focus on short-term returns, and the possibly-too-regular stock market summaries and statements.
Research has actually shown that the more frequently people look at their stock returns, the more they trade, and the more they are prone to switching at exactly the wrong time!
So while you certainly need to keep a general eye on what’s happening, don’t let what you see on a minute level impact your investment strategy without taking an overall view. It’s a bit like weighing yourself everyday – the fluctuating numbers can send you into a flurry and delude you off the carefully planned path.
It’s just logical
There are some very logical guides that help investors avoid letting emotions ruin their plans, including:
- having a balanced and diversified portfolio (and this doesn’t mean perfectly evenly spreading your money, but apportioning the total over a variety of investment types, to suit the riskiness of the investment and how comfortable you are with risk)
- not selling investments at the bottom of the market and not buying in a bubble
- not making investment decisions based on short-term data or on the spur of the moment
- not following the herd!
An aside – predictably irrational
While the field of “behavioural finance” assumes investor irrationality, it also suggests people make mistakes consistently and predictably. Yet even when it says investors may not be rational, it doesn’t necessarily mean they are inconsistent, unwise or arbitrary; they may have good reason - to them - for their decisions.
However, this doesn’t necessarily imply that investors can easily profit from potential market inefficiencies. Even when a rational investor recognises an incorrectly priced asset, strategies to profit from that pricing can be both risky and costly.
Emotions do have a place
Believe it or not, your emotions can – and should - have a place in your investment strategy. The trick is, to know your emotions around money, and therefore how they are likely to cause you to feel if the market is up, down or otherwise.
Any good financial planner will determine your “investment behaviour” through a series of questions. Once that is known, you should factor it in to your investment strategy, and know that while you may feel slightly uncomfortable in a certain market situation, you will be comfortable knowing that that prospective feeling was taken into account in the first place. Don’t let sudden emotions drive impulsive investment decisions.
History rides again
Many people’s investment decisions are shaped by their emotional response to their past money experiences - including what their parents taught them, how their parents reacted to money and what youthful negative experiences they had with money.
For instance, someone who experienced severe lack in their childhood may be quite risk averse. It’s fine to have a conservative strategy if that’s what you feel comfortable with - just don’t let hot-running markets, and the “ooh, I must get in that now” thought negatively influence your actions!
Solid is following a plan
Good investment strategies focus on your short, medium and long-term goals, and are reviewed regularly and sensibly. Good plans are also formulated for you - not your money. Greed, fear, “what everyone else is doing” and the “next hot thing” do not come into the equation!
If you have any questions about your “investment behaviour” or how your strategy is formulated, do not hesitate to contact us – even if it’s in between our regular planning meetings.
Source: “Investor Behaviour: What is behavioural finance?” by Kaplan Professional.