Get to grips with your biases - there's no such thing as a rational investor
Most economic theories and investment strategies are based on the notion that investors are rational and consistently make decisions that are in their best interests. I believe that accepting that there's no such thing as a rational investor is key to being able to take good advice and thus succeed in reaching your investment objectives.
Here are some insights into human behaviour that affects investment decisions.
Broadly speaking, there are two types of biases. Cognitive biases come about when your brain isn't quite firing on all cylinders, and as such these biases are relatively easy to remedy. Emotional biases stem from your impulses, feelings and intuitions and are much harder to mitigate.
Let's assess whether you're cognitively biased.
A cricket bat and ball cost R110 in total. The bat costs R100 more than the ball. How much does the ball cost?
If you said R10 you'd be wrong. The correct answer is R5.
Don't feel bad if you failed. More than half of Harvard students can't answer the bat-and-ball question correctly. No matter how many times you hear it, you'll still want the answer to be R10. It just feels right. And when it comes to investing, what feels right is often given more credence than what is right.
Balancing the head and the heart
Now let's review three of the most common emotional biases.
Recency bias explains our willingness to believe that something is more likely to occur again simply because it's happened recently. The opposite is also true: if it's been a long time since something last took place, we tend not to expect it to happen again. Neither of these intuitive feelings is correct. Think of why gamblers can go so horribly wrong. They don't accept that every time you flip a coin there's an equal probability of heads or tails.
Loss aversion refers to our tendency to strongly prefer avoiding losses over acquiring gains. Losing R500,000 on the stock market can cause you distress for days, but the emotional high of gaining the same amount wears off within hours. Loss aversion also helps to explain why people sell when market prices are falling - and in so doing lock in their losses - instead of using the dip to buy in at a good price.
Finally, familiarity bias describes the fact that when it comes to choosing - investments, clothes or ice-cream flavours - we all prefer to stick with what we know. The thing is, you can get away with having a wardrobe full of the same brand, but you can't afford to have an undiversified portfolio. Entrepreneurs who consistently reinvest in their own businesses, instead of creating external retirement portfolios, are a good example of how recency biases place investors at risk.
I've been working as a financial adviser for 12 years, but even I have cognitive and emotional biases, which is why I seek advice from my business partners when it comes to managing my family's money. When it comes to my clients, however, I have the advantage of experience, impartial judgment and access to planning and analysis software, which helps my clients mitigate risk and make rational decisions.
So, what can I do about it?
• First up, find an experienced certified financial planner who you like and, very important, trust. Whoever you choose is going to be involved in some of your most important and personal decisions, so set the bar high and don't be afraid to speak to a couple of advisers before you make your choice. (But do remember that using multiple advisers is a disastrous form of diversification.)
• Once you've established a good relationship, take the advice and stick to your long-term plan.
• It's also important to focus on things you can control and not fret too much about things you can't. You can control your choice of investments, but you cannot control the market.
• Do take advantage of debit orders to make monthly contributions to your retirement investments. This will allow you the benefits of rand-cost averaging and spare you the inevitable disappointment that comes with trying to time the market, which not even the most experienced investment managers can get right.
The long and the short
Emotional and cognitive biases are completely normal; in fact, they're one of the things that make us human. What's important is to know, first, how to recognise them and, second, how to stop them in their tracks when making important investment decisions.
• Hugo, financial planner of the year for 2018/2019, is a director of Sterling Wealth Group