Common behaviours that could hurt your investments
I’m about to toss an Australian $1 coin. One toss only. Pick one - heads or tails. Now, take a piece of paper and write the number one, and put an “H” or “T” next to it, depending on your choice.
Before I toss the coin, consider the following. This is not the first toss of the coin today. In fact, I’ve flipped it four times, and this is the fifth toss. The results of the four tosses were: H, T, H, H. Before I toss for the fifth time, write the number two on your sheet of paper. Now, put an “H” or a “T” next to it – your choice in light of the new information. You may stick to your original choice, or move to the other.
Behavioural Finance is the study of real human decision-making, rather than the classical economic model’s human that is a “rational agent maximising utility”. Theoretical rational economic agents always make the most efficient economic choices. Meanwhile, here in the real world, we see investors make decisions that clearly take non-economic factors into account. In some cases, investors appear to act against their own best (economic) interest.
There are many causes of these uneconomic decisions. Take a look at your sheet of paper. If the letters next to the numbers one and two are different, your second choice is subject to a “framing error”. On any given coin toss, the probability of Heads or Tails remains equal, no matter what has occurred beforehand. Any investor that changed their decision based on the additional framing information did not act rationally.
If you changed your choice, don’t be downhearted. You merely demonstrated that you act like a human being. And framing errors are just one of the information processing errors that investors make every day. Other investor challenges include hindsight bias, confirmation bias, herd behaviour, gamblers’ fallacy and anchoring errors.
Another clear distortion of investor behaviour is experiential learning. This is the tendency we all have to give greater weight to our own experience. Where that experience is positive, it reinforces the behaviour. This may explain why so many Australian investors remain overweight financial stocks. On the other hand, a negative experience leads to avoidance. Many studies show that the impact of negative experiences is greater than the effect positive experiences.
This brings us to the Great Financial Crisis. The GFC, in most cases, had a huge negative impact on investors. The scars of that experience can be traced in the investment decisions of today.
This table shows, in broad terms, the asset allocation of SMSFs from 2004 to 2016. Each of the coloured bars represents a year, and the percentage of SMSF funds invested in that asset class for that year:
The experience in shares shows investors’ responses both mirror and lag their responses. The purple bar is 2007. Note how the percentage of SMSF funds dropped away sharply post GFC. Share holdings hit a low point in 2009 – the bottom of the market (“be greedy when others are fearful”). Since then, shareholdings have increased but are still nowhere near pre-crisis levels. This is one of the scars of the GFC, because the numbers tell us that over the long term, shares offer the best risk-adjusted returns.
The debt shows similar fluctuations in risk appetites. Holding cash and bonds is considered less risky than other asset classes. Not surprising, this asset class saw strong flows after 2007, moderating as conditions slowly improved.
The stickiness of property investment is harder to rationalise. A flight to “hard” assets is understandable in the aftermath of the GFC. While not rational, investors believe there is intrinsic value in assets like property and gold, and part of this esteem is the ability to touch the asset. Many investors equate tangibility with lower risk. This is despite the fact that it was largely plummeting house prices that sparked the global rout. The fact that this bias continues to show in SMSF asset allocation as a whole is another scar from the GFC.
Published: Tuesday, February 14, 2017
New on Switzer
- Hold your breath. US vote could sink stocks! 24 Mar •
- Turnbull should be careful of compromise 24 Mar •
- Investor Signposts: The week ahead 24 Mar •
- Investing in Microcaps 23 Mar •
- Myth: BPA free is a safer alternative 23 Mar •
- Warren Chant 24 Mar •
- Shane Oliver 24 Mar •
- Rudi Filapek-Vandyck 24 Mar •