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Understand yourself before you understand the market

“Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

This quote from Sir John Templeton, who was referred to by Money Magazine as ‘arguably the greatest stock picker of the 20th century’, highlights that emotional factors such as optimism and pessimism may influence or even drive market cycles and ultimately individual investor experience.

How investors ‘behave’ can have a significant impact on their overall success as an investor. After all, a market only rises when there are more buyers than sellers, and only falls when there are more sellers than buyers.

Behavioural finance is the field of science that studies how the mind works when it comes to dealing with money. It seeks to understand what factors influence individuals to make certain investment decisions.

This is an introduction to behavioural finance along with some ideas that investors might want to consider to help manage some of the emotions around investing.

Every finance expert knows that Modern Portfolio Theory includes the assumption that investors are rational. Yet as we engage with investors, we know that behind the rational façade lies the emotional and irrational world of individual investor behaviour.

Following are five behaviours which are driven more by emotions than facts, influencing investor decisions and contributing to investment mistakes.

1. Loss aversion – desire to avoid the pain of a loss

Simply stated, no one wants to lose money. Loss aversion is the pain felt when an investor has experienced a loss in the past, and doesn’t want to revisit that experience again. In tests conducted by Kahnemann and Tversky, pain from making a financial loss was proven to significantly outweigh the pleasure made from making a financial gain. For investors, an example is the reduction in share portfolio values experienced as a result of the Global Financial Crisis. The subsequent retention of large holdings of cash in investor portfolios and reluctance to re-enter equity markets, despite strong valuation support and improved market performance, highlights this.

2. Anchoring – holding fast to the past

Anchoring is the tendency to use a previous decision as the key input to a future decision rather than taking into account new or more relevant information. This occurs not only in the field of investments, but in purchasing decisions of all kinds. The negative reaction of Australian consumers to higher petrol prices might largely be as a result of their previous experience of lower petrol prices, rather than a reflection of the market price determined by the level of supply and demand.

3. Herding – our tendency to follow the crowd

Market swings are often the most obvious form of herding, as investors pile in or out of investments together. Many will recall the tech bubble in 2000, when investors piled into tech stocks, often disregarding the fundamentals of the investment. Subsequently, as the value of tech stocks retreated in 2001, the herd followed by selling out. Good technology companies with sound businesses were sold off along with those companies with unsustainable business models. The herd moved on and provided professional long term investors with the opportunity to buy excellent businesses at low prices.

History has shown it is difficult, if not impossible, to time markets. Investors who take their cue from the herd risk buying high and selling low, like during the tech bubble, which is the opposite of the approach they should take.

Sir John Templeton reflected on this, saying: “to buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude and pays the greatest ultimate rewards.”

4. Availability bias – most recent is most relevant

A survey conducted by Franklin Templeton Investments in 2010 through to 2012 highlights the impact of availability bias on investors. The survey asked US investors how the stock market had finished the previous year. Whilst 2008 produced a significant negative result for the S&P500, the subsequent years from 2009 to 2011 produced positive years. Yet approximately half or more of those surveyed each subsequent year thought the market had been negative or flat. In the absence of accurate information their brains drew on the information available to them, even though it was no longer current.

5. Mental accounting – the value of money varies with the circumstances

One of the early researchers on behavioural finance, Richard Thaler, coined the phrase ‘mental accounting’ to explain how people treat money differently depending on where it comes from. Earned money is often invested more cautiously than unexpected ‘bonus’ funds from a tax refund, inheritance or lotto win. These ‘bonuses’ are often splurged on excesses or invested in high risk/high reward investments rather than being allocated to an existing savings and investment plan.

By understanding and recognising that as investors we are not always rational, how then can we invest or advise investors with confidence?

Firstly, try to understand your own biases. What combination of reason and emotion influences your approach to investing? Knowledge of these will help you manage your own responses to different investment experiences.

Secondly, have a long term plan. A financial plan acts as a roadmap and forms the basis of any sound, long term investment strategy. A plan also provides a reference point in times of emotional investing stress. Research shows that investors with a written plan are more successful and more satisfied with their investments.[i]

Thirdly, take time to make decisions. Allowing time to reflect rather than rushing in prematurely and discovering that the buzz often associated with making an investment is not always followed by the euphoria of investment success.

And finally, don’t underestimate the value of seeking professional advice and assistance.

For further reading:

  • Franklin Templeton Investments, Breaking the Cycle of Investment Regret, 2013.
  • Kahneman and Tversky, Mental Accounting Matters, Journal of Behavioral Decision Making, 12:183-206 (1999).
  • Dan Ariely, Predictably Irrational.
  • The 2012 Franklin Templeton Global Investor Sentiment Survey designed in partnership with Duke University Professor Dan Ariely and Qualtrics.

Footnote i: Ipsos Reid, Value of Advice Survey, October 4, 2011. Based on supporting data from Canadian Financial Monitor data.

 

Jim McKay is Director of Advisory Services at Franklin Templeton Investments.

 


 

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