Chapter 16

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Behavioural Finance

Let me introduce you to your investor self

‘The investor’s chief problem – and even his worst enemy – is likely to be himself.’

Benjamin Graham

Successful investing requires forming objective, emotionless and rational views about assets’ future performance. This is a key to correctly formulating an investment strategy matching your investment objectives.

Dynamic Strategic Asset Allocation (SAA) is used to position your portfolio for the long (5–10 years) and medium term (1–5 years). It is grounded on what markets are objectively implying. It does not necessitate you to form subjective views on how markets are likely to behave over the short term (up to 12 months).

However, you may wish to reposition your portfolio due to short-term developments. Geopolitical events, such as an unexpected dissolution of the Eurozone, or economic events, such as the USA suddenly sliding into a recession, could be adequate reasons to act considering the short term. Dynamic SAA might be slow in capturing such events or completely overlook them.

Accounting for short-term situations requires the formation of short-term market views and a swift reaction. Tactical Asset Allocation (TAA) addresses this. But, before turning to TAA, we will cover how you are likely to be deceived by the market. And you are not the only one; the market misleads us all. TAA is subjective and bad behavior can lead to bad investment decisions.

We are all humans (at least most of us). We make mistakes. Whilst we aim to rationally forecast the future, we should acknowledge our investor psychology and mental biases affecting our rational decision making.

Behavioural finance explores the effects of psychological, social, cognitive and emotional factors on financial decision making and the impact on markets. Our mind is an amazing machine; however, it is susceptible to limited available information, prejudices, anchoring and illusions. It is easy to play tricks on it.

In this chapter we review some of the common behavioural biases that tend to affect decisions of investors, both amateurs and professionals. Being aware of these biases is unlikely to eliminate them. But, being aware of them, you will, possibly, identify when you are under their influence, take a step back, think rationally and decide with a clearer head.

When you manage your portfolio, your decisions are likely to be affected by behavioural biases. For example, volatility of markets might induce you to sell when markets fall close to the bottom and buy when markets rise close to the top. This behavioural tendency turns otherwise potentially harmless volatility into a wealth-destroying activity.

By understanding the behavioural biases, you may be able to mitigate their impact and control your potentially harmful instincts.

Herding and myopic thinking

‘Successful investing is anticipating the anticipation of others.’

John Maynard Keynes

Two of investors’ most common behavioural tendencies are herding and myopic thinking.

Herding is people’s inclination to think and act in the same way as the majority. Investors often do what everyone else appears to be doing because of a fear of missing out. They use a flawed logic that if everyone is doing something, it must be right. Herding is one cause for unsubstantiated rallies (bubbles) and sell-offs (crashes).

We are conditioned to believe collective wisdom is superior to any one individual’s opinion. When seeing people queuing for a new restaurant, we eagerly join the line, assuming it must be fantastic since everyone obviously thinks so.

An example of herding is the 1990s technology bubble. Investors piled up on technology stocks since everybody seemed to be doing so. Their prices far exceeded fundamentals. Companies were valued based on traffic in websites, rather than any foreseeable profitability.

It all ended badly. The bubble exploded in 2000. Herding then went the other way when everyone sold all tech stocks indiscriminately. The higher the peak, the harder the fall.

The issue with herding is that when everybody is buying something, it is probably already overvalued. Try avoiding it by doing your homework. Do not fly on auto-pilot, make a conscious effort to form your own opinion and take time to make decisions. You are managing your private portfolio; it is all right to stand out from the crowd – it is nobody’s business but your own.

The second common behaviour tendency is short-termism (myopic thinking). It is everywhere: cannot help but eat a fourth piece of delicious pizza, loaded with calories, whilst sabotaging your diet; buying a red Ferrari you cannot afford out of an urge, whilst derailing long-term financial planning; or chasing recent returns, hoping latest success will be replicated.

It is easy to fixate on the market’s short-term movements. However, as a saver for retirement, you are here for the long haul. It does not matter what markets do over a week or a month; it is noise. It matters what markets do over 5–10 years.

Not only is it nearly impossible to predict markets over a week or two, and recent winners might be a passing fad, but also swinging your portfolio back and forth generates performance-biting transaction costs.

Investing is a marathon, not a sprint. Do not let news distract you, leading to instinctive but flawed decisions out of fear and greed. Position your portfolio to benefit from market movements over a number of years, not next week. This is one advantage of dynamic SAA. It takes a long-term view based on asset valuations, helping to avoid short-termism.

Prospect theory

Nobel laureate Daniel Kahneman and Amos Tversky developed the prospect theory, which describes how people value gains and losses differently. Losses have a larger emotional impact than equivalent gains, leading to risk aversion.

Let’s play.

Pick one of two choices:

• 50% chance of gaining £1,000 and 50% chance of gaining £0.
• 100% chance of gaining £500.

Now, pick again one of two choices:

• 50% chance of losing £1,000 and 50% chance of losing £0.
• 100% chance of losing £500.

Which ones did you choose?

Most people pick B (certain gain) in the first exercise and C (gamble for a chance of not losing) in the second one.

In both cases, A and B and C and D are equivalent, having the same expected result.¹ The reason for the common choices is loss aversion – the propensity of focusing on minimising the downside. Losing hurts more than gaining pleases.

Prospect theory leads to a number of biases in decision making.

Framing effect means the way a problem is described leads to systematically different decisions. It depends whether the description emphasises the potential profit or loss. It is all in the positioning and marketing.

For example, choose between two investments:

• Investment with 5% probability of losing money.
• Investment with 95% probability of gaining money.

Which investment do you prefer?

Most people select B, although the risks of A and B are equivalent. The focus in A is on losing and in B is on gaining. The way information is presented sways decisions. This is the skill of salespeople.

Disposition effect explains why some investors hold on to losing investments for too long and sell winning investments too soon. Continuing to hold a loser avoids admitting failure and the hurtful feeling of losing. Impatiently selling a winner generates the joy of success.

Feelings and emotions, rather than cold, objective monetary calculations, drive decisions.

Mental accounting

Mental accounting is people’s inclination to arbitrarily categorise economic outcomes, such as winner account and loser account.

For example, you bought two assets:

• You paid £100 for A; its price now is £80.
• You paid £60 for B; its price now is £80.

You think the price of both is going to plunge. Which asset do you sell or hold?

Most people choose to take profits, selling B – it is in the winner account, and keep holding A, avoiding crystallising a loss – it is in the loser account.

You enjoy winning but want to avoid admitting losing, forgetting the concept of sunk costs. Sunk cost has been incurred and cannot be recovered. There is nothing to do about it; no point of throwing good money after bad, trying to salvage it.

Assets A and B should be sold since your prospective view is negative on both. The reference point of a purchase price is irrelevant. It doesn’t matter whether you’re in a profit on one and losing on the other. The past is in the past. Let bygones be bygones. Forward-looking views should drive decisions. But yet, psychologically it is more difficult to sell at a loss than at a profit.

Cognitive biases

Cognitive biases are patterns of deviations in judgement, whereby inferences about people and situations may be drawn in an illogical fashion.

Anchoring is a tendency to rely too heavily on the first piece of information offered when making decisions. An irrelevant value influences the answer.

For example, you are looking to buy a house. You view two identical houses in the same street. On the first one, the asking price was £400,000 but the seller agrees to sell it for only £375,000. On the second house the seller insists you pay the £375,000 asking price.

On which house do you make an offer?

Most people would go with the first house. Its initial asking price was £400,000 and they negotiated it downwards. The opening asking price is an anchor or reference point. They feel delighted getting a good deal, £25,000 less than the asking price.

But the two houses are identical. The second house’s price is as good as that of the first. Anchoring is one reason shops offer discounts on the original price. It makes you feel you get a bargain. Sometimes, retailers offer goods at a discount from the onset – they have never asked for the full price. It is a selling gimmick.

Over-confidence and over-optimism describe the propensity of people to have too much subjective confidence in their judgement, far above its objective accuracy.

When asking fund managers whether they think they are better than the median manager, everyone would say yes. Statistically, however, half are above and half are below the median.

Most managers would speak with conviction about their views on the future. However, most managers get it wrong.

When a person claims to know the exact truth about anything, it is safe to assume this person is inexact. Subjective certainty is inversely proportional to objective certainty. The more that people are uncertain they are right, the more they feel they need to show proof validating their claims.²

Confidence is important, but be realistic where you should be confident and where you should be humble, admitting you can use advice. Financial markets can be humbling after experiencing some disappointments. It is better being uncertain and cautious, than confident and wrong.

Confirmatory bias means people tend to see what they want to see to confirm their view. If you are bullish on stocks, you are inclined to agree with positive analysis, corroborating your view, ignoring negative analysis, contradicting your view. You listen more to those who boost your confidence, not to those disagreeing with you.

However, it can be beneficial to listen to others; they may offer perspectives you did not consider. This is one benefit of teamwork.

Hindsight bias is the thinking you knew it all along – the writing was on the wall; it was obvious. It is easy to explain what happened in the past with the benefit of hindsight. The challenge is having foresight, forecasting what will happen in the future.

Often, economists are excellent at articulating the past and present. But, whilst explaining the future with confidence, they are often clueless. When presenting their views with conviction, people tend to believe they know what is going to happen. Rarely, they do.

Self-attribution bias is people’s tendency to assign skill to good decisions and luck to bad decisions. If your investments do well, it is because of your skill in selecting the right ones. If your investments do poorly, it is because of bad luck. Self-attribution is a way to boost self-confidence.

Sample size bias is the habit of giving too much significance to conclusions based on small samples.

For example, you toss a fair coin five times, each time getting heads. You conclude the coin always falls on heads. However, you reached a conclusion based on a small sample – it could be a coincidence. Tossing the coin 100 times, getting heads each time, could lead to a reasonable conclusion that it is biased.

You find a correlation between the number of snowy days in Scotland and the performance of the FTSE 100 Index, concluding that when it snows in Scotland, the UK stock market performs well. However, this is an example of mixing spurious correlation and causality. December and January happen to be strong months for the stock market on average and the depth of winter. It is a coincidence.

Another example is calculating standard deviation or average based on 12 monthly returns. This sample is far too small to reach statistically significant figures. You need at least 36 or 60 monthly observations to do so.

It is rather common for experts to misuse and present statistics in such a way that supports their story. Representativeness bias helps them, as people tend to judge by appearances, not likelihoods.

For example, a fund manager boasts the fund has posted positive returns over the last six months, every month in a row. What does it say about the fund?

Not much really. The fund appears to do a good job. But it is over such a short time frame and you do not know how it compares to a benchmark and peer funds. Perhaps markets have rallied and most other funds did much better.

Recency effect is people’s propensity to preferentially remember the recent past. For instance, if equity market has gained over recent years, investors tend to be complacent, increasing equity holdings disregarding risks. They focus on recent past, forgetting history.

The opposite tends to occur following a crash. Investors’ attention is on the downside, staying away from the market, due to recent bad experience, although it may be a buying opportunity. Recent experience has a big impact on our emotions.

The status quo and endowment effects explain why once owning something you may value it more than others, feeling an affinity towards it. When selling an investment, you tend to ask a higher price than that you would pay to buy an equivalent one.

For example, when selling a house, you feel emotionally attached to it. You would probably ask more for it than its fair value because it is yours.

Being aware of the biases affecting your decision making is the first step. Markets drop and your surviving instinct tells you ‘sell, run away from danger’. But you are impacted by the mood of doom, gloom and fear.

One way to alleviate the biases is teamwork. When having an urge to sell or buy, run your idea by someone else. It could be your adviser, spouse, a trusted family member or a good friend. Peer review by someone emotionally detached can highlight when your thinking is not entirely rational.

Listening to someone disagreeing with you might be annoying. But it may be more valuable than listening to someone agreeing with you. Do not boost your ego; boost your returns.

Another way to alleviate biases is following a process as mechanical and systematic as possible, leaving emotions aside.

Know yourself

‘The time to buy is when there’s blood in the streets.’

Baron Rothschild

Know your investor self. You feel depressed or panicky when markets correct or euphoric and overly brave when markets rise. Often, after markets fall, it is a buying opportunity. It is too late to sell anyway just to materialise losses.

After markets rally, they might be overvalued, overbought and crowded. If you are in, consider taking profits – fight your greed for more. If you are out, it might be better to wait for a correction and a better entry point. But do not wait too long and risk missing the rise whilst waiting on the side lines.

This is contrarian investing. News is priced in quickly. For markets to continue falling or rising, more bad or good news is needed. When it looks bad or good, the worst or best might be behind us.

Follow a disciplined valuation-based investment process, with an eye on the medium term, fed by different objective inputs to overcome the effects of behavioural finance. Common sense, judgement, clear head, intuition and experience (grey hair) are all required for consistent successful investing.

Investing requires making brave decisions, facing the unknown – we do not know what the future holds. We must make rational decisions with the information we have.

Investing is not an exact science; it is a social science. It is an art as much as it is a science. To succeed, you do not only need to know economics and mathematics, but also crowd psychology. Understand the ‘animal spirits’ of the masses.³ To be a good investor, you need independent thinking, scepticism and emotional self-control.

At least by being aware of the biases clouding the markets’ judgement we increase our chances of triumph, in particular when making decisions such as tactical asset allocation.

Summary

• Herding and myopic thinking are two behavioural tendencies of investors, often leading to mistakes.
• Prospect theory explains risk aversion. Losing hurts more than gaining pleases. You are likely to take more risk to avoid losing than try to profit.
• Framing effect means the way information is presented can affect decisions, rather than the information itself. We judge books by their covers.
• Mental accounting is the tendency to categorise economic outcomes, such as winners and losers. You are more likely to sell at a profit than at a loss, even when having a negative view on an asset, using the purchase price as a reference instead of focusing on the future.
• Anchoring is the tendency to rely too much on the first piece of information as a reference point for future decisions.
• Overconfidence is putting too much subjective weight in your judgement, surpassing its objective accuracy. Be confident where you have an edge and humble where you need advice.
• Hindsight bias is the propensity to think that what happened was obvious. Explaining the past is easy. Forecasting the future is hard.
• When having an urge to make a decision, use peer review as a sounding board to avoid making emotional, irrational decisions. Stop, clear your head, do your research, think why you are making the decision and ensure it follows common sense.

Notes

¹ £500 = 50% × £1,000 + 50% × £0 = 100% × £500; −£500 = 50% × (−£1,000) + 50% × 0 = 100% × (−£500).

² Inspired by Bertrand Russell.

³ ‘Animal spirits’ is a term John Maynard Keynes used in his 1936 book The General Theory of Employment, Interest and Money to describe the instincts and emotions influencing human behaviour.