No one sets out to make a bad investment. Yet people make them all the time. One reason is that we underestimate the extent to which emotion can affect our decisions. Another is we become overconfident in our ability to predict the future and often rely on gut feeling rather than logic.
This article is from our latest edition of MarketWatch, an in-depth report focusing on the Psychology of Investing.
This is often simply down to how our brains work. We are familiar with the imprudent strategy of buying high and selling low, yet investors do it again and again. Looking back over many centuries there are numerous examples of really clever people making bad investment decisions.
For example, the father of neo-classical economics, Adam Smith, reportedly lost a large part of his wealth investing in the South Sea Bubble in the 1700s, and John Maynard Keynes, who was an avid speculator, saw most of his personal wealth wiped out as a result of the 1929 Wall Street Crash. More recently in the run up to the global financial crisis, many people became overconfident, greed overcame fear, and numerous investors took on excess risk and leverage just before the crash.
A relatively new field of academic study called behavioural economics examines why, despite all the lessons from the past, investors tend to repeat the same mistakes. The initial findings suggest that our brain is simply not designed to make rational financial decisions or navigate complex financial markets.
These findings are critical to understanding how the market works. Traditional finance theory is built on the assumption that we have perfect information and that market participants are rational. However, we know this is not how the world or the market behave.
The genesis of behavioural economics can be traced back to the 1970s, when Nobel Prize winning psychologists Daniel Kahneman and Amos Tversky conducted an influential series of experiments that became known as Prospect Theory. Their work showed that people tend to make decisions based on intuition rather than logic, and that the psychological impact of losing on an investment is about twice as strong as making a profit.
They also found that being rational and intelligent are not one and the same. Previously the view was that IQ was the single measure of an individual’s intelligence. We now know that there are several other forms of intelligence, some of which are more important than IQ when making investment decisions.
In their 2016 book 'The Rationality Quotient', Keith Stanovich, Richard West and Maggie Toplak devised an intelligence test aimed to quantify an individual’s ability to think rationally called the Rational Quotient (RQ) test. This test measured people’s ability to make good investment decisions. Through empirical research, the authors showed that RQ is a much better indicator of an individual’s capacity for good judgement and decision making than traditional intelligence measures, including IQ. Warren Buffett explains it as IQ being the horsepower of an engine, but RQ is the actual output.
There have also been a number of studies to determine if there are any specific characteristics, whether cultural or gender based, that make some investors more successful than others. A recent study by asset managers Fidelity, which analysed 8 million accounts by gender, showed that women’s investments tend to outperform men’s. It found that in general, “women tend to hold a more long-term, conservative view with their investments; fewer women were fully invested in equities. By comparison, men were 35% more likely to make stock trades”. The study also found that women were more willing to accept expert advice.
A recent global study by wealth manager Credit Suisse showed that cultural background also impacts investor behaviour. The study showed that Anglo-Saxon investors tend to tolerate the greatest losses, Germanic investors are the most patient, while African investors tend to be the most impatient.
Although this field of study is relatively new, it acknowledges that people are not perfect. It also looks to explain how we actually make decisions, make mistakes when processing information and why we do not always act rationally.
The hope is that if we are aware of our own inherent biases we can try to avoid some of the pitfalls of investing. There are two types of behavioural biases to be aware of - cognitive errors and emotional biases. Cognitive errors arise when an investor is unable to analyse information properly or has incomplete information. Emotional biases illustrate how impulse, intuition and feelings result in decisions being made.
By better understanding how our brains operate and why we make bad decisions, we can try to eliminate some of the human biases that tend to fail us as investors. Although understanding biases does not automatically mean you will avoid mistakes, it should help improve your chances of success. One way to deal with these biases is to set out a structured rules-based approach to investing. Some of the rules we think can assist include: