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MarketWatch November 2017

The Psychology of Investing

David Finn 49 x 49px.jpg David Finn
Investment Analyst
Keith Williamson_author.jpg Keith Williamson
Investment Analyst

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.

The Psychology of Investing

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.


 

What to watch out for

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.


From IQ to RQ

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.


Does it vary by nationality or by gender?

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.


How the brain trips us up

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.
 

Table 1: Behavioural biases

Source: Davy

 

Ways to mitigate against behavioural biases

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:
 

  • Have a plan:
    Implementing a financial plan with your adviser will help set a clear roadmap for what you are trying to achieve. This is a fact finding exercise that determines critical details such as net worth, spending and saving trends, and investment objectives. Questions that should be considered include: how much might you need to fund your retirement?; what do you want to leave behind?; and who do you want to leave it to? Answering these questions will help determine the optimum investment strategy for you. Only if your goals, ambitions or circumstances change should you deviate from this plan. This reduces the risk of making a rash decision.
     
  • Set the rules of engagement:
    Once you have agreed a plan, set out a defined investment strategy. In wealth management circles this is a formal document called an investment policy statement (IPS). An IPS helps define important elements when building a portfolio, such as your personal tolerance for risk or losses and your time horizon.
     
  • Invest counter cyclically:
    Do not make the mistake of being too risk averse when assets are attractively valued or taking on too much risk when things are expensive. Arguably this is the biggest failing of investors’ emotional biases. The largest returns tend to be generated at the start of an investment cycle. This may mean investing when your intuition tells you not to. The same is true towards the end of a cycle. This is often the time investors make the mistake of taking on excessive risk (see David Hillery's article on 'Investing counter cyclically' on pages 8 & 9).
     
  • Do not over trade:
    Numerous studies have shown that studying your portfolio too often can cause overtrading which may lead to poor investment outcomes. Set a rule of scheduling periodic checks, and establish the ground rules for when to make changes and when to leave your portfolio alone.
     
  • Diversification:
    As much as we all only want to pick winners, in practice this is impossible to achieve. Experienced investors understand that each asset or stock in a portfolio plays a different role.Quite often the worst performing asset in any one year tends to be one of the strongest in the next.
     
  • Stick with the plan:
    Setting a rules-based approach is only good if you stick with the plan. Following agreed rules can eliminate some of the mistakes investors are prone to making.


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