Human Biases That Lead To Investment Missteps

Foreword from ShareInvestor

This article “Human Biases That Lead To Investment Missteps” by Genevieve Cua was first published in The Business Times on 23 Apr 2014 and is reproduced in this blog in its entirety.

TRADITIONAL portfolio theory has it that investors think and behave rationally, and that markets are efficient, incorporating all available information into prices.

In the last couple of decades, however, market’s boom/bust cycles have largely overturned this notion of rationality. In fact, there is ample evidence that markets are often irrational, overshooting fundamental values on the upside and downside. This is because investors themselves are irrational, driven largely by excesses of fear and greed.

Behavioural finance is an academic discipline that has emerged to study investor behaviour, errors and the human decision-making process. As Vanguard said in a paper, behavioural finance takes insights from psychology and applies them to financial decision making.

Here are some of those which have emerged on human biases that often lead to investment missteps:

Overconfidence: People tend to have “unwarranted confidence” in their decision making, Vanguard said. In the investment realm, this is manifested when investors overestimate their ability to pick winners or to time markets. They typically go against the advice to diversify.

Vanguard cited a study of affluent investors who reported that their stock-picking skills were crucial to the portfolio’s success. “In reality, they were unduly optimistic about the performance of the shares they chose, and underestimated the effect of the overall market on their portfolio’s performance.”

Overtrading: Investors who have too much confidence in their abilities often trade too often, with negative effects on their portfolio. Vanguard cited research by Brad Barber and Terry Odean, who studied retail brokerage accounts. They found that the most active traders earned the lowest returns.

Loss aversion: Behavioural finance suggests that people more strongly prefer to avoid loss than to have a gain. Some studies suggest that the emotions arising from losses are twice as powerful as gains. In investments, this is seen in investors’ reluctance to realise a loss. They are likely to hold on to losses in the desire to break even. Vanguard said: “This means the investor shows highly risk-averse behaviour when facing a profit (selling and locking in the sure gain) and more risk tolerant or risk-seeking behaviour when facing a loss (continuing to hold the investment and hoping its price rises again).

Past performance as indicator of the future: Investors often base their decisions on the historical performance of stocks. This leads to a tendency to extrapolate past price trends into the future.

Inertia: Confusion, uncertainty and the desire to avoid loss may cause investors to freeze and procrastinate on their investment decision. That is why some pension funds have “autopilot” schemes where members who fail to make a choice are put into a default asset allocation.

Rules of thumb: This is one of the major findings of behavioural finance research, that investors often use heuristics or “rules of thumb” to make decisions rather than a rational analysis. There are some major biases at play. One is anchoring, where investors use a fixed value or stock price as a reference point or anchor, rather than objective analysis. For instance, investors may watch a stock drop in price from a previous high, and refuse to sell until it retouches the previous high. The historical high, however, may have no bearing on where the stock may trend in the future.

Another related bias is called recency, where people place more importance on recent events, projecting that into the future. This may explain why following the 2008 crash, many investors remained on the sidelines, even in the face of evidence that world economies were on the mend.

All these biases are reasons why most investors need a financial adviser to help them to overcome inertia and make reasoned decisions. A discretionary portfolio, where the manager makes decisions on asset allocation and individual securities, also helps.