How can investors curb their tendency towards irrational decision-making?
The first step in tackling the risk of losses is to acknowledge the effect of overconfidence
Despite numerous behavioural finance findings on irrational investor behaviour, and its dramatic negative consequences on returns, investors are disinclined to believe they are at risk of making irrational decisions. In their minds, past success in their personal investments proves they are immune to this particular risk. They believe their investments will eventually turn positive.
Call me a pessimist, but the JSE’s unsustainable 30-year bull run, coupled with increased complexities due to globalisation and technological disruption, means the confidence that investors feel based on past success may be misplaced.
Behavioural psychology’s popularity has risen in the past decade, mainly because of outstanding consumer publications by pioneering academics. They found that people were systematically irrational because of several fundamental behavioural biases, with mistakes being consistently repeated and, in Dan Ariely’s words, “predictable”. When findings in behavioural psychology are applied to economics (behavioural economics) and the world of financial markets and financial decision-making (behavioural finance), the implications of irrational decision-making become more real.
Despite the conclusive nature of behavioural finance findings on how irrational investor behaviour damages returns, few investors have controls in place to mitigate those risks. To be fair, it is difficult to safeguard against flaws that are complex to quantify and observe, but this is not necessarily the reason for investors’ inaction. The likely reason is our inherent optimism- overconfidence biases: we believe these academic findings simply don’t apply to us individually. This overconfidence means we overestimate our personal abilities despite evidence to the contrary.
The first step to address the risk of losses is to acknowledge the impact of overconfidence in making us ignore our susceptibility to detrimental behavioural biases. The next step is to take stock of the potential personal damage of those biases.
Providing examples of the consequences of our behavioural biases in a local context may increase the relevance to South Africans of otherwise largely foreign academic findings. Though the examples below are not necessarily applicable to all local investors, they do bring home what is often seen as a foreign problem.
The JSE was the world’s best-performing market from 1900 to end-2016. Even during the global financial crisis JSE investors were rewarded with an exceptional compound annual return of 18% over 10 years. Our long-term memory is dominated by an incredible period of being a JSE investor. However, the past three years were more difficult. The JSE has returned less than 2.5% compound annual growth, of which a large portion is attributable to a handful of shares.
While it is not unusual for markets to go through periods of underperformance, SA is facing significant challenges given the macroeconomic and political headwinds, and there is no immediate indication of a turnaround. So, a belief that broad-based local growth will return to the historical mean of global overperformance is a long shot. While it will be possible to generate local investment returns, it is going to become increasingly difficult to achieve world-beating returns entirely from the JSE.
A logical move is international diversification. Yet our behavioural biases might persuade us otherwise. Based on our historical understanding of the JSE, we might remain disproportionately invested locally, expecting a return to global outperformance. Four biases are primarily responsible:
- The anchoring bias — investors’ tendency to hold on to a belief (the JSE’s consistent outperformance) and apply it as a reference point for future decisions.
- The self-attribution bias — investors’ tendency to attribute successful outcomes to their own actions. This leads them to expect that, irrespective of the depressed outlook, as individual investors they can still find returns locally.
- The gambler’s fallacy — when investors see patterns where none exist. In this case the pattern is that the JSE always goes up, leading to the expectation that it will revert to that mean in the future.
- The home bias — preference for investments we are familiar with, largely because they are local. This prevents us from investing adequately offshore.
Merely recognising these biases may be enough to make us adequately pursue an international diversification strategy. Yet, even in that case one further behavioural observation potentially stands in the way of executing this strategy effectively: the disposition effect. This is our tendency, in the event of a liquidity constraint, to sell profitmaking investments ahead of loss-making investments. For South Africans this bias may nudge investors to sell their profitable positions ahead of loss-making ones when creating liquidity to diversify offshore. It is an incredibly costly bias since, historically, profitmaking investments have continued to outperform, and loss-making investments have continued to underperform.
Understanding our biases and the potential cost to investment returns is the foundation for protecting ourselves from their negative consequences. Deliberate controls need to be put in place. The first, and easiest, mitigation control is to consult a trusted independent third party (a friend, investment club or professional investment adviser) about our investment decisions. Most decisions influenced by our behavioural biases are objectively irrational, so independent advisers can identify poor decision-making and question its reasons.
We are all susceptible to behavioural biases, despite what our inherent overconfidence tells us, and in SA we are particularly exposed to the resulting downside risks. Our plea is that investors be deliberate in managing their susceptibilities and run investment decisions past qualified independent advisers. In the long run, it may make all the difference to their returns.
• Bashall is with Anchor Capital.
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