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Investment Strategy: More head, less heart

by Craig B Pheiffer

Behavioural finance is a field of study that combines elements of cognitive psychology and economics and aims to explain why investors behave the way they do in the markets. The decision-making processes of the individual are at the heart of the matter and behavioural finance recognises that individuals often do not behave rationally when investing in the markets and are slaves to emotions such as fear and greed.

These emotions, together with the actions that they generate, are often blamed for the poor investment results achieved by both individual investors and fund managers. This behavioural finance view of the investor is different from the traditional view of the investor as a rational and utility-maximising individual. A number of psychological biases or cognitive illusions that impact investor behaviour and cause investors to behave irrationally have been identified.

Brabazon (2000) classifies these illusions as stemming either from heuristic decision processes (rules of thumb) or from the adoption of mental frames (placing the decision in different contexts). Included in the first category of investor illusions are overconfidence, representativeness and the gambler’s fallacy, while the second category includes mental accounting, loss aversion and regret aversion.Over-confidence

Just as some individuals are over-confident in their knowledge or abilities, investors are often too confident in their own ability to select stocks and pick market highs and lows. If you had to put a group of investors into a room and asked them who would be able to outperform the average of the group over the next year, you would most likely find that most of the group would express the view that they were better than average. Just as some individuals are over-confident in their knowledge or abilities, investors are often too confident in their own ability to select stocks and pick market highs and lows. If you had to put a group of investors into a room and asked them who would be able to outperform the average of the group over the next year, you would most likely find that most of the group would express the view that they were better than average. Of course not everybody can be better than the average. Well-documented reasons for over-confidence include the “illusion of control”, biased expectations of the future (i.e. irrational expectations) and the “illusion of knowledge”. In the first case, investors believe that they have some influence over share prices, for example, if they are more closely placed to the action (such as trading online). In the latter case, investors believe that the more they know about a particular situation or investment opportunity then the more likely it is that their desired outcome will come to pass.

Frequently, over-confidence stems from incorrectly ascribing past investment success to one’s own ability rather than to other exogenous factors or an improvement in the market or sector as a whole. In other words, the investor may consider his 10% portfolio gain to be all his own making, but may ignore the fact that the overall market is up 20% for the same period. One of the downsides of over-confidence, and there are many, is that investors take fewer but bigger bets on their investments.
Frequently, over-confidence stems from incorrectly ascribing past investment success to one’s own ability rather than to other exogenous factors or an improvement in the market or sector as a whole. In other words, the investor may consider his 10% portfolio gain to be all his own making, but may ignore the fact that the overall market is up 20% for the same period. One of the downsides of over-confidence, and there are many, is that investors take fewer but bigger bets on their investments.Barber and Odean (2001) found in the investment stakes that men tended to be more over-confident than women. In their analysis of people’s trading patterns they found that the more people traded, the worse they did, on average. They also found that men traded more than women and hence fared worse than women investors. RepresentativenessInvestors under the illusion of representativeness base their investment decisions on perceived patterns in the market and often extrapolate past experience into the future. In so doing, they place far too much emphasis on the recent past. Ritter (2003) points out that this “law of small numbers” is one reason why, after a number of years of high equity returns (such as 1982-2000 in the US and Western Europe), investors start to believe that these returns are normal. This is also the reason why investors chase the market-darling stocks (remember Didata?) and ignore the recent poor performers.

Another representativeness illusion is that good companies make good investments and this is frequently not the case as the market has already priced the good company at a premium, limiting the upside price potential. It is very often the case that the struggling company with the poor results has the most potential to outperform.
Another representativeness illusion is that good companies make good investments and this is frequently not the case as the market has already priced the good company at a premium, limiting the upside price potential. It is very often the case that the struggling company with the poor results has the most potential to outperform.The gambler’s fallacy

The gambler’s fallacy relates to the erroneous belief that a trend must always reverse itself. A roulette punter, for example, who witnesses a string of red numbers and believes that the next number must be black, is under the illusion of the gambler’s fallacy.
The gambler’s fallacy relates to the erroneous belief that a trend must always reverse itself. A roulette punter, for example, who witnesses a string of red numbers and believes that the next number must be black, is under the illusion of the gambler’s fallacy.The gambler’s fallacy has two versions and this can best be illustrated by considering ten random flips of a coin that all turn out to be heads. The punter who thinks that the next flip of the coin has to be tails (i.e. the long run of heads just has to be broken), is suffering from one form of the illusion, while another punter who thinks that the trend is well established and the next flip will also be heads is suffering under the other version.

Both versions of the gambler’s fallacy are evident in the markets in that some investors who see a share price constantly rising expect the trend to reverse as a matter of course, while others will see no end to the share price extravaganza (no examples needed!). The result is that some investors never take profits when they should because they are always expecting more and end up losing out when the share price does turn. Conversely, some investors never find themselves in a winning share because they believe that they have “missed the boat” after a small price gain and keep waiting for that inevitable price reversal to get into the counter. When it doesn’t come they truly have “missed the boat”.
Both versions of the gambler’s fallacy are evident in the markets in that some investors who see a share price constantly rising expect the trend to reverse as a matter of course, while others will see no end to the share price extravaganza (no examples needed!). The result is that some investors never take profits when they should because they are always expecting more and end up losing out when the share price does turn. Conversely, some investors never find themselves in a winning share because they believe that they have “missed the boat” after a small price gain and keep waiting for that inevitable price reversal to get into the counter. When it doesn’t come they truly have “missed the boat”.Mental accounting

This is the tendency that investors have to pigeonhole their investments, or put them into separate categories (“mental accounts”) based on differing investment objectives, and then to not combine the overall result of all of the mental accounts.
This is the tendency that investors have to pigeonhole their investments, or put them into separate categories (“mental accounts”) based on differing investment objectives, and then to not combine the overall result of all of the mental accounts.Having a trading account and a longer-term retirement portfolio account is an example of mental accounting. The investor considers that losses on the trading account aren’t that bad because they don’t affect the retirement portfolio where in reality the investor’s overall wealth has decreased. In this instance, the investor is accounting for the two portfolios separately instead of considering his wealth in totality.

Another example of mental accounting is where an investor opens up a savings account and earns 8% p.a. but has an Access mortgage bond that costs 12% p.a. to finance. Mental accounting is also the reason why some investors take a different view of dividends versus capital gains (income requirements aside) instead of looking at the total return on their investments.
Another example of mental accounting is where an investor opens up a savings account and earns 8% p.a. but has an Access mortgage bond that costs 12% p.a. to finance. Mental accounting is also the reason why some investors take a different view of dividends versus capital gains (income requirements aside) instead of looking at the total return on their investments.Loss aversion

Brabazon (2000) explains loss aversion as being based on the idea that the mental penalty associated with a given loss is greater than the mental reward from a gain of the same size. This often means that investors play it safe when they are in a profit situation but are more willing to take chances to recoup losses from underwater positions.
Brabazon (2000) explains loss aversion as being based on the idea that the mental penalty associated with a given loss is greater than the mental reward from a gain of the same size. This often means that investors play it safe when they are in a profit situation but are more willing to take chances to recoup losses from underwater positions.Reference dependence is a behavioural finance bias exhibited by investors where, for example, an investor with a loss-making purchase is keen to sell the share only once it has regained its original purchase price (the reference point). Instead of considering the share on its merits and future profit potential, the investor is simply looking to get his money back and all other considerations become secondary. More astute investors forget the original purchase price of their shares and continuously value their holdings on current prospects. The pattern where investors avoid realising paper losses and seek to realise paper gains is what Ritter (2003) describes as the disposition effect.

Most investors who buy Anglo American at R140 per share, for example, and watch it fall to R130 per share are loathe to sell it until it gets back to R140. Ritter notes that the disposition effect manifests itself in investors realising a lot of small gains but few small losses, a behaviour that is akin to tax-maximisation!
Most investors who buy Anglo American at R140 per share, for example, and watch it fall to R130 per share are loathe to sell it until it gets back to R140. Ritter notes that the disposition effect manifests itself in investors realising a lot of small gains but few small losses, a behaviour that is akin to tax-maximisation!Regret aversion

This is a desire by investors to avoid feeling regret over any of their investment decisions. Investors could regret, for example, not having sold Dimension Data at R70 or not having bought it at R2. Sometimes investors even regret selling shares and making a profit when the prices of those shares continues going up after the sale.
This is a desire by investors to avoid feeling regret over any of their investment decisions. Investors could regret, for example, not having sold Dimension Data at R70 or not having bought it at R2. Sometimes investors even regret selling shares and making a profit when the prices of those shares continues going up after the sale.The problem with regret aversion is that it often encourages investor herding behaviour and, as Brabazon notes, investors are led to investing in “respected stocks” because they carry implicit insurance against regret. This may also explain why fund managers sell losing stocks so that they don’t have to answer difficult questions from their investors at reporting time.

Unfortunately it is very difficult to divorce one’s emotions from investment decision-making, especially when it is hard-earned, after-tax money that you’re putting into the market.
Unfortunately it is very difficult to divorce one’s emotions from investment decision-making, especially when it is hard-earned, after-tax money that you’re putting into the market.Avoiding some of the pitfalls and anxieties described above is much easier, however, if you do your homework on each company’s fundamentals before entering the market. Adequate diversification of your investment portfolio with similarly well-researched counters will help reduce the unsystematic risk of that portfolio and will help you sleep better at night. All that will remain is for you to wait for your good work to pay off. And don’t forget to take the profit!!

References:

Barber, B. and Odean, T. (2001). “Boys will be boys: Gender, overconfidence, and common stock investment”, Quarterly Journal of Economics 116, 261-292.
Brabazon T. (2000) “Behavioural Finance: A new sunrise or a false dawn?”, Proceedings, CoIL/EvoNet Summer School, University of Limerick, September 2000.
Ritter, J.R. (2003). “Behavioural Finance”, Pacific-Basin Finance Journal Vol. 11, No 4 (September 2003), 429-437.

Craig B Pheiffer is Chief Investment Strategist of Sasfin Frankel Pollak Securities. He can be contacted on (011) 883 2337 or by e-mail on cpheiffer@sasfin.com

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The Big Change is a business strategy blog and newsletter published by Arthur Goldstuck, managing director of World Wide Worx, a leading technology research organisation based in Johannesburg, South Africa.

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