In a previous article on this column we discussed how herding behaviour influences investors and the pitfalls of falling into the trap of following the trending ideas when it comes to investing. The excitement around hot ideas and market perception, often on the bull side of the market, usually leads to some kind of “irrational exuberance”, as famously coined by former Fed Reserve chair Alan Greenspan. In this article we focus on other behavioural characteristics or biases of investors that highlight why we are not always the rational individuals we think we are. The biases are often difficult to shake off and they contribute to most of the poor investment decisions we make. These biases are interlinked and inherent in all of us at varying degrees and are essentially the reason behind markets being inefficient and assets being mispriced. As such, it is only with careful introspection and conscious effort that biases can be effectively managed and reined in.
with NESBERT RUWO & JOTHAM MAKARUDZE
The first and probably the most dominant bias is an overconfidence bias. We all would like to think that we know what we are doing when it comes to most things. We will rate ourselves as above average drivers, or having above average intelligence; the same applies to investing. In terms of investing, overconfidence bias implies an overestimation or exaggeration of one’s ability to successfully pick investments. Some investors get “lucky” usually in their first foray into investing and they confuse this luck with skill, which breeds this overconfidence.
It is important to keep in mind, however, the subtle difference between confidence and overconfidence. While confidence implies realistically trusting one’s abilities, the lack of which is paralysing and not good, overconfidence is an overrated assessment of one’s knowledge or control over the situation, often held against evidence to the contrary. Often, overconfidence is evident in hindsight, but how does one detect and avoid overconfidence in oneself as an investor? Typically, individuals that reflect this bias will tend to have an escalation of commitment when confronted with information that suggests that their initial decision was incorrect. They entrench their views, often putting all their eggs in one basket with the belief that their information and intuition is superior to others in the market. Overconfident investors will typically overtrade their portfolios in search of investments that confirm their bias. Complete avoidance of this bias is almost impossible as we are emotional humans after all. It is also important to document and review your investment record and have an understanding of how your emotions influence how you invest your hardearned money.
The second bias is familiarity. We all have a natural tendency to want to stick to what resonates with us. We look to buy investments in our home countries in companies whose products and brands we are familiar with, or companies we work for on the pretext that we know these companies well. As such, despite the fact that it is now much easier than in the past with the proliferation of the internet to research other investment opportunities and diversify across geographies, most of us shy away from investing internationally. Rational investors would consider practically all available investment opportunities, understand the business models of potential investments and then strategically allocate their investments across different sectors, geographical markets and across currencies to extract the full benefit of diversification.
Anchoring is another behavioural bias that most investors exhibit. The basic idea behind anchoring is that an investor becomes fixated on past information, events and values irrespective of new price sensitive information. Investors in this bias category also tend to hold on to losing investments with a view that they will “come back”. The investors anchor the value of the investment to the value the investment once had, that is a buy-price anchor. Some investors have an attraction towards a share which has fallen considerably from its previous or all-time high. How often have investors lost money when the share price has continued falling unabated? Other examples of anchors include earnings forecasts that are anchored on prior period earnings level, and initial public offers are usually anchored at the midpoint of the published price range. A lesson that can be extracted from this is: do not be anchored on a specific number, event or piece of information — understand the fundamentals of the investment before making an investment decision.
The bottom line is that biases cannot be completely eliminated but may be minimised. Every investor must take steps to minimise the adverse effects of biases. These steps include understanding a potential investment’s fundamentals (or business model), setting a risk-rewards threshold for each investment, thereby setting an investment or trading rule. It takes discipline though to override one’s emotions and follow own rules. With so much “noise” in the investment markets, investors tend to sway with the wind without necessarily following their investment rules. Warren Buffet aptly puts it like “you don’t have to swing at everything — you can wait for your pitch. The problem when you are a money manager is that your fans keep yelling, ‘Swing, you bum!’”. It’s the behavioural folly.
Nesbert Ruwo (CFA) and Jotham Makarudze (CFA) are investment professionals based in South Africa. They can be contacted on firstname.lastname@example.org