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Recognise your biases: Mental traps that could undermine your investment success.

15 Dec 08          

Comment:
Words of wisdom from a successful investor in this regard:

"The most important quality for an investor is temperament, not intellect.......You need a temperament that neither derives great pleasure from being with the crowd or against the crowd".

- Warren Buffett

Cobus du Plessis of the Institute of Behavioral Finance and Business Development Manager at EFS Investment Solutions, writes that most people think they are good at managing money. However, if this is true - why then is it that senior executive on big incomes are unable to save and retirees lose their life savings through schemes and scams? What is it about money that causes otherwise sensible people to take risky chances and make poor decisions?

In recent years, Behavioral Finance, commonly defined as the application of psychology to finance, has become a hot topic for study, especially in the USA. Very little research has been done in South Africa. It is only recently that certain organisations and universities started to research the subject in a South African context.

This article is meant to merely give a short introduction into the field of standard (rational) finance versus behavioral finance and describing some of the mental biases or decision mistakes that investors and financial planners tend to make.

What is Behavioral Finance?

The big debate is about rational markets versus irrational markets and rational economic man (Homo economicus) versus behaviorally biased man. The two primary sub-topics of Behavioral Finance are therefore:

  • Behavioral Finance Micro which examines the behaviors or biases of individual investors that contradict classical economic theory, and
  • Behavioral Finance Macro which describes "anomalies" in the efficient market hypothesis, for example, fundamental, technical and calendar anomalies.

    For the purpose of this article I'm focusing on the biases of individual investors. Stemming from the neoclassical economics, Homo economicus is a simple model of human economic behavior, which assumes that principles of perfect self interest, perfect rationality and perfect information govern our economic decision making. Economists like to use the concept of rational economic man since it makes economic analysis relatively simple and it allows them to quantify their findings, making their work easier to digest.

    Behavioral Finance challenges the bases for these underlying assumptions arguing that:

  • Human behavior is less the product of logic than of subjective impulse such as fear, greed, pain and pleasure.
  • Perfect self interest would preclude people from volunteering, helping the needy and philanthropy.
  • It is impossible for every person to have perfect knowledge especially in the world of finance

    Investor behavioral biases

    Behavioral biases fall into two broad categories, cognitive and emotional, both yielding irrational judgments.

  • Since cognitive biases stem from faulty reasoning, better information and advice can often correct them, and
  • Because emotional biases originate from impulse or intuition rather than conscious calculations, they are difficult to rectify.

    More than 50 of these biases or mental traps exist. As investors and financial planners we need to recognize these biases that have the potential to destroy our wealth faster than a bear market.

  • Anchoring bias, the tendency to latch onto a piece of data against which we judge all future information. When we invest we may become anchored to the current prices of assets and thus vulnerable to incorrect future decisions. How many of us bought a property at say R500 000. A few years later it is valued at say R3 million. When we decide to sell we don't want to let go at say R2.6 million although it may be the best decision (anchored at R3 million).
  • Endowment bias, the tendency to value an asset more when we hold the property rights to it than to when we don't. Think of how many times you've hold onto shares or other assets such as paintings that were inherited, regardless of whether retaining it is financially wise. Could it be that we fear that selling it will demonstrate disloyalty to the person from whom we inherited.
  • Loss aversion bias which prevents people from unloading unprofitable investments, even when they see no prospect of a turnaround.  Some industry veterans have coined a diagnosis, "get-even-itis" to this phenomenon, an affliction in which you could hold onto a losing investment in the hope that you will get your money back.   
  • Regret aversion which can cause you to shy away unduly from markets that have gone down recently, fearing that if you invest, the market might continue its downward trend, prompting you to regret the decision to invest. Often, however, depressed markets offer bargains and as an investor you can benefit from these undervalued investments.

    Other biases include framing, overconfidence, conservatism, mental accounting etc. The key to guarding against these mistakes is to be properly prepared so that you keep perspective during the inevitable fluctuations in the market. Knowing yourself well enough to be aware of your biases and then to master your mind is the key to ensuring that you make the right decisions. Don't get caught up in the herd and don't be greedy.

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