The study of behavioural investing is a component of the broader category of behavioural economics. The field is a more modern area of research that does a good job of explaining why traditional economic and finance theories do not always hold. Traditional theories tend to focus on mathematical relationships and make assumptions about how individuals will act based on the information that they have available to them. A common assumption is that investors will act “rationally”. Behavioural research focuses more on psychology, rather than mathematics, and explains why many traditional theories don’t work at times.
In many cases, investors will make poor investment decisions based on behavioural biases without even knowing it. Furthermore, mistakes are not just made by novice investors, investors with higher levels of sophistication and even professionals routinely fall victim to lapses in judgement. We present five of the more common behavioural biases and provide examples that many investors can probably relate to.
1 – Illusion of Control
Many people believe that they control their own destiny. Indeed, freedom of choice arguably allows individuals to pick and choose what they wish to pursue in life: a career path; who they spend time with; or what products they buy. It is a natural extension for many to believe that they can control the outcome of their investments, whether it is conviction in an individual security, an investment style or strategy, or achieving an overall wealth objective.
The truth is, the outcome of any investment is uncertain because it is dependent on the future, which is unknown to everyone. Markets are also massive. No individual investor or organizational entity is big enough to exert control over a market, and regulators of markets put rules in place so that no investor has any kind of unfair advantage.
The danger when an investor steadfastly believes that they can control outcomes, is that they lose sight of risk. If you mistakenly believe that you will eventually be “right” and persist in making the same decisions where you have previously been wrong, your losses can compound quickly, eventually leading to ruin if you are not careful. Although no one can control what happens with the markets, it is possible to control the risk that you take so understanding the various risks that you are taking should be of paramount consideration when making investment decisions.
2 – Overconfidence
Overconfidence is closely related to the illusion of control, believing that your ability to achieve success is better than it actually is. There are a lot of smart people in investing – very, very smart people. Yet, almost every investor who purchases securities on their own, or through an advisor thinks that their insight is correct.
The return for any investment market (the “market return”), is determined by the sum of all trades made in that market over any measurement period. Every trade will have a buyer and a seller. Relative to the market return, all trades form a zero-sum game: for every winner, there is a loser of equal value (less trading costs). Realistically, you have a 50/50 chance of being right or being wrong on any particular active investment decision.
If you were to gather a room full of investors (amateur or professional) who actively make decisions on their investments and ask them: “How many of you believe that you will achieve better-than-market returns?”, what do you think the answer would be? Well, if anyone does not think that they can beat the market, then they should not even try – they would be better off just buying a passive index fund that delivers precisely the market return, less an almost negligible fee. So, you should expect that number to be very high, probably close to 100%, yet the actual number will be 50%.
3 – Self Attribution
One of the most often asked questions in investing is “Was it luck or skill?”, when determining success in past decisions. Self attribution involves assigning the answer to one’s own decision…with very predictable patterns: any successful decision was based on skill; any unsuccessful decision was based on bad luck.
Common comments when a decision was correct include: “I knew that was going to happen”; “My process correctly predicted that”; or “I saw this trend developing”. Positive self attribution is routinely combined with exaggeration – “I doubled my money on that stock” – omitting the fact that half of the position was sold after a 10% gain. Conversely, in self attribution, it never seems to be the investor’s fault when things go wrong: “Nobody could have predicted that”; “That outcome was one in a million”; “I wasn’t wrong, just early”.
Self attribution clearly feeds overconfidence and vice versa. Also perpetuating the problem is the very nature of statistics. If we assume that all investment decisions are based on chance, or follow a random process, then there is a predictable pattern of outcomes over time, commonly referred to as a “bell curve”. This pattern concludes that most investors will generate average-like returns, and that there will be an equal number who experience better-than-average and below-average returns. At the extremes, there will be the very fortunate and very unfortunate. Was it luck or was it skill? It depends on who you ask!
4 – Recency
Placing too much emphasis on recent events to influence decisions is known as recency bias. The definition of recent is a bit open to interpretation, and could mean the events of today, the past week, month, year or even several years. This bias has become particularly important as the access to information and speed at which it is being delivered has never been greater.
An object in motion, tends to stay in motion – Newton’s first law – is an example of recency bias. Specifically, if a stock has performed well recently, it is assumed that it will continue to perform well. This rule will work precisely up until the time that it doesn’t. Momentum investing, as this is often referred to, tends to work well in strong trending markets, but subsequently tends to suffer when the trend reverses, as it always does. No trend lasts forever, and over a full cycle, momentum investing strategies tend to deliver the exact same returns as every other investment strategy: the market return.
Another very common investor mistake is to look at the top performing funds over the past year, or the past three years, or even longer, and pick a fund after it has achieved tremendous success. There is an overwhelming amount of empirical evidence to suggest that this is a poor investment strategy since today’s heroes often become tomorrow’s zeroes. Ironically, have you ever noticed an investment advertisement that boasts of “awful” performance results? Marketing has been around a lot longer than behavioural economics, but they both conclude that people react positively (perhaps irrationally) to recent good news.
5 – Herd Mentality
It is fitting to finish with the behavioural bias of herd mentality. The past few years have given rise to an extraordinary number of examples of investments that do not seem justifiable by traditional finance theories. Meme stocks, cryptocurrencies, and negative interest rates are all anomalies that represent irrational investor behaviour, yet they have all made regular headlines since 2020.
Headlines fuel herding, but are not the only culprit. Herd mentality can be combined with illusion of control, overconfidence, self-attribution and recency bias…plus many other biases that we haven’t even touched upon. Have you heard this conversation at a cocktail party: “I have a can’t miss opportunity for you. I bought some shares of Company XYZ a few weeks ago and it is already up 10%. I knew this was going to be a winner, and their new technology is going to revolutionize the industry. If you get in now, I’ll bet you’ll make triple your money in a year.”
The storyteller above can be thought of as a cheerleader and will very likely tell the story to many people. Not everyone will act on the “advice”, but some might, and then become an additional cheerleader, potentially leading to a chain reaction. If you change Company XYZ to cryptocurrency, then you have probably heard this story, and it certainly seems that a chain reaction has transpired. Of all the information provided in the story, there is no evidence to support the “value” of the investment, the superiority of the technology, or any kind of rationale for potential profit – never mind the potential for loss. It is a story based purely on hype which is all that is needed by investors prone to herd mentality.
Investors can sometimes be their own worst enemy, making mistakes that can be avoided, and then refusing to believe that it was their fault. Despite what too many investors believe, investing is not simple. The allure of fabulous wealth and good fortune in investing can be blinding and may lead to very costly mistakes. Independent and objective advice from an investment professional that understands behavioural biases and does not have an emotional attachment to your assets, may be your best option to help you avoid making mistakes.
Written by James Gauthier, Chief Investment Officer at Justwealth.