The irrational investor - why we act like that

Anyone who has tackled financial economics in college will certainly recall professors filling blackboards with algebraic symbols that purported to explain precisely how financial markets work: the capital asset pricing model, the efficient-market hypothesis - brilliant Nobel Prize-caliber material.

That information had one flaw. While the models explained things generally, they assumed that people make financial decisions with the rationality and precision of an astrophysicist calculating a moon launch. However, "rational" does not always describe the way we approach our finances. After all, if we're so rational, why are we not rich?

Common approaches to personal finances

When it comes to sorting out complicated material like our financial affairs, we tend to be sentimental, illogical, and badly flawed. At least, that is the premise of a fast-rising academic discipline called Behavioural Economics.

We would like to introduce some classic ways investors fool themselves. Do not be alarmed if you recognize yourself in any of these; it would be surprising if you didn't.

The Gambler

Suppose that you brought $1,000 with you to Las Vegas, and won $2,000 on your first bet. Chances are you will mentally divide the money into two portions: the hard-earned cash you squeezed from your paycheck, and the easy money you won at the roulette table. You will continue to spend the first wad relatively cautiously but the second you will throw around with abandon. If we were economically rational, we would value the gambling win as much as the money we work for. But that is not how we usually react.

A form of mental accounting known as "framing", which is applying peculiar yardsticks and arbitrary time periods to assess whether you're winning or losing, may influence how small investors will respond to a correction or a high performing investment. Instead of using logic and placing money in an investment that is low-risk, the gambler in us wants to put the money into the investment with the best short-term performance, considering it to be found money.

Asymmetric Loss Aversion

A stranger comes up to you on the street and offers to flip a coin. Heads, you have to pay him $500; tails, he'll pay you an agreed amount. How much would that amount have to be to make the game attractive? Assuming the person is trustworthy, common sense says that any offer over $500 tilts the wager your way. Yet you still balk. If you're like most people, you're not tempted by anything under $1,000.

If you react like this, you are suffering from a condition known as "Asymmetric Loss Aversion". Its cause is simple: Losing money feels twice as bad as making money feels good. In other words, the value of a win in a fifty-fifty game of chance has to double the cost of a loss before we feel comfortable with the gamble. This phenomenon prevents some investors from taking money from safe investments because they simply cannot envisage the risk/reward ratio of another type of investment. This way of thinking can result in even greater losses in the long run.

Clueless Anchors

Smart investors understand how little they know about the future of the market. The rest of us find the uncertainty so hard to tolerate that we impose patterns where none exist. And we create "anchors" - apparently logical rules of thumb - to help decide issues about which we have no clue.

Random anchoring has long been a favorite pastime among Wall Street analysts. Without it, how could they fix a proper price for those Internet stocks with no earnings or any imminent hope of success? Their thinking is as follows: "Amazon.com trades at about 20 times sales, so software.net should go public at, say 14 times...." Left unexamined is whether Amazon at 20 times sales made economic sense. It probably did not.

These anchors pressure investors to value investments based not on prudent investment measures but on the relative value compared to other investments, which may also be overvalued.

Overconfidence

A key benefit we derive from mental gymnastics such as anchoring is a pleasant, if inappropriate, sense of confidence and feeling of control over our surroundings. For example, in surveys, a whopping 80% of people consider themselves to be better-than-average drivers.

Of course, confidence is not entirely a bad thing. It gives us the energy and optimism to deal with challenges, even if it makes us ineffective at estimating the odds that we will succeed. Since investing means putting off enjoying today's wealth in the expectation of gaining more to enjoy tomorrow, optimism is plainly a prerequisite. However it can be costly if it gives you the illusion that you can determine the future when you really are unable to do so.

A brand of overconfidence that every investor succumbs to at least once is the "hot hands" fallacy. This is an element of that innate human talent for discovering patterns in what may actually be a series of random events.

People tend to think that any mutual fund manager who has had five good years in a row can do no wrong. In reality, there are so many fund managers that a few are bound to have exceptional returns. Statistically, it is impossible to determine whether those returns were due to luck or skill. However, this detail fails to deter investors, who are confident that they have discovered a pattern of superior performance, and throw billions of dollars into top funds. Such managers do not repeat their success any more often than they would by sheer chance.

Investors then follow the trend, which could mean unloading good steady investments for the new hot investment.

The Rear-View Visionary

One reason we are convinced of our ability to forecast economic events is that we firmly believe we have done so (or could have done so) in the past. We could not have, of course; we are just not good at recalling risk assessments made months ago, especially once we experience the outcome.

Our inept but overconfident predicting helps explain one of the more profitable loopholes in classic financial economics. Studies have demonstrated that out-of-favour stocks, with low prices relative to earnings, sales, and cash flow, tend to perform better over time than high-priced glamorous stocks. One reason for this is that overconfident investors tend to project continued rates of growth for glamour stocks indefinitely. Expectations toward value stocks, on the other hand, are low so that decent earnings tend to be a pleasant surprise.

As we have advised repeatedly, the best way to invest is simply to:

• take a long-term approach
• diversify appropriately based on time frames and objectives, and
• rebalance on a regular basis

If you would like to review your portfolio, please call our office for an appointment.