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Behavioural finance: Investing and our emotional biases

Conventional economic theory (known as the efficient market hypothesis) assumes that everyone behaves rationally when making an important decision such as investing their wealth. However, behavioural finance practitioners counter that the observed facts do not support this hypothesis.

They point to various phenomena, including investment bubbles and market crashes, as evidence that individuals are not mechanical, and that we are all influenced by our historical experiences and expectations.

In this, the second in our occasional series, we will look in more detail at what are termed our emotional biases.

What do we mean by emotional biases?

It is often said that investors are driven by two competing feelings: fear and greed.

Greed clouds our thinking when the values of investments are rising, and fear takes over when these values are falling. This can lead us, as individuals, to overreact and to become overly euphoric or overly pessimistic.

When sufficient numbers of us get caught up in this it can lead to prices rising far in excess of their fair values, or crashing far below them.

Whilst these are valid observations the reality, as with most things, is more complicated and there are many ways in which our emotions can overrule our intelligence to subconsciously filter the facts.

Behavioural finance recognises four key ways in which emotional biases are expressed through our actions:

  • belief perseverance, confirmation bias and conservatism,
  • overconfidence and over-optimism,
  • self-attribution or hindsight bias, and
  • regret avoidance or loss aversion.

We will look more closely at each of these in turn.

Belief perseverance, confirmation bias and conservatism

Belief perseverance drives us to follow the same processes and strategies using the same information sources, even when they fail us or continue to produce less than ideal outcomes.

Whether we realise it or not we go into many interactions with a preconceived opinion. During a first encounter it can be difficult to shake these opinions off, as we tend to selectively filter and pay more attention to information which supports our opinions whilst simultaneously ignoring or rationalising everything else.

This tendency to give too much weight to facts that agree with our current views whilst ignoring or giving less weight to facts that contradict them is called confirmation bias.

Think about your preferred news source. It is a natural human tendency to listen to people who agree with us; because it feels good. It feels comforting to hear our opinions reflected back to us and we therefore gravitate towards media channels based on confirmation bias.

And this can limit our ability to make objective decisions.

In extreme cases it can lead us to form our views first and then spend the rest of the day looking for the information that supports them and which make us look right. This skews our frame of reference and makes us subject to faulty decision making as a result.

Because of this tendency to cling to our previously-held beliefs, conservatism causes us to hesitate before acting on new information, especially where this information should dictate a particular action or to change our strategy.

This hesitation eventually leads to different investors taking action at different times. This makes markets inefficient, providing opportunities for some to benefit from the inaction of others.

Overconfidence and over-optimism

While confidence and optimism can be beneficial, overconfidence and over-optimism are often detrimental. The distinction is subtle and often difficult to assess. Confidence suggests a realistic trust in one’s abilities, while overconfidence implies an overly optimistic assessment of one’s knowledge, skill or level of control over a situation.

Overconfidence has two components: an illusion of knowledge (the quality of our information), and an illusion of control (our ability to act at the right time). These can lead us to taking much more risk than we perhaps should because:

  • We believe our personal performance is higher than it really is.
  • We perceive situations as less risky than they actually are.

Over-optimism also has two components: timing optimism (we believe we can work faster than we are really capable of) and desirability effect (or wishful thinking). These can lead to us moving too hastily because:

  • We cut corners or skip crucial stages of our analysis because we haven’t given ourselves enough time.
  • We want something to happen so badly we overestimate the odds of it happening ahead of the odds for any of the alternatives.

These can lead us to believe we are better than others, due to a false sense of skill, talent, or self-belief. They can be dangerous biases and are very prolific. Yet understanding what other investors are doing is one of the most important skills in finance and investing.

Overconfidence in one's abilities can lead to higher portfolio turnover (frequent buying and selling of investments) and to lower returns.

One study analysed the trades of 10,000 investment-only accounts to discover if frequent trading led to higher returns. Having set aside sales made to offset gains for tax purposes, and those made to release cash, the study found that the purchased stocks underperformed the sold stocks by 5% over one year and by 8.6% over two years*.

In other words, the more active the investor, the less money they made. This study was repeated numerous times across many countries and the results were always the same. The authors concluded that traders are, "basically paying fees to lose money."

Not surprisingly, men tend to trade more actively and achieve lower returns than women, perhaps because men have greater overconfidence in their abilities.

Self-attribution or hindsight bias

Linked to overconfidence, this is the habit of attributing favourable outcomes to our expertise (“I always knew I was right”), and unfavourable outcomes to bad luck, or to some external and/or unexpected event.

We like to flatter ourselves that we possess special insights or talents by attributing the cause of an outcome based on what is in our own best interest. When everything is going according to plan it’s clearly due to skill, but when things don’t go to plan, it’s bad luck.

This is a dangerous limit to our learning because in practice there could be a whole host of reasons why we’ve had an unexpected success or an unexpected failure. Likewise, we might have a good outcome despite our wrong reasoning. What’s important is to acknowledge that when we have wrong reasoning and a bad outcome, we have clearly made a mistake and we can learn from those mistakes.

*Source: Tim Parker: Four Behavioural Biases And How To Avoid Them, 2013.

From a psychological standpoint, we may experience hindsight bias as a result of a human need to find order in the world; we create explanations which allow us to believe that events from the past were predictable.

But it can sometimes lead investors to find erroneous “links” between the cause and the effect of an event, thereby oversimplifying the situation and making poor decisions in the future.

  • Consider the 2008 financial crisis. Many now claim that all the signs were there and everyone could see it coming. But it didn’t stop it coming because back in 2007 any analyst or investment professional who raised their concerns was not listened to.
  • The same kinds of hindsight bias can also be found for essentially any historical bubble from the tulip bubble of the 1630s to the dot.com bubble of the early 2000s. But if it had been truly obvious, it is likely that investors would not have bought into the euphoria, and the bubble would not have burst.

George Soros, a highly successful investor, is known to account for this tendency by keeping a journal of his reasoning behind every investment decision. We could all learn from this discipline of recording the reasons behind our decisions and mapping their outcomes.

Hindsight bias is also linked to confirmation bias in that we focus on data that confirm our explanations for past events, and this makes them seem inevitable or obvious.

Even being aware that we maintain confirmation and hindsight biases (and are therefore likely to be overconfident) is not sufficient to prevent us from falling prey to them. We must be prepared to robustly test our hypotheses, even finding someone to act as a dissenting voice of reason.

If forced to defend your investment decisions and viewpoints from a contrary opinion, we are more likely to see the holes in our arguments.

Regret avoidance or loss aversion

This is the flip side of overconfidence and causes us to make decisions in a way that allows us to avoid feeling emotional pain in the event of an adverse outcome. It is a tendency to be fearful of losses and try to avoid them rather than focusing on making gains.

A major discovery of behavioural finance is that we are twice as sensitive to losses as we are to gains. So losing £100 feels twice as ‘bad’ as gaining £100 feels ‘good’. Or gaining £200 evokes the same level of feeling as losing £100.

  • For instance, most investors would avoid an investment where there was a 50% chance of either earning or losing £50,000 on a £100,000 investment because the £50,000 lost would have greater immediate use, and therefore greater value, than the £50,000 potentially gained.

As humans, we try to avoid the feeling of regret as much as possible and often we will go to great lengths, sometimes illogical lengths, to avoid having to ‘own’ the feeling of regret.

For example, the fall in share prices at the end of 2018 led many retail investors to withdraw from the market for fear of realising further losses. In reality, share prices have risen for much of the year to date.

We believe that remaining invested at all times allows us to capture the rapid recovery phase that, historically, has frequently followed a downturn

Conclusion

Many of us will go to great lengths to rationalise our historical investment decisions, especially failed investment decisions. In extreme cases, this could lead us to continually delay selling positions that are not generating adequate returns in the belief that one day they will ‘come right’.

And sometimes despite all the evidence to the contrary.

Confirmation and hindsight biases prove that seeing is not necessarily believing.

  • The former leads us to be more attentive toward new information which confirms a preconceived opinion or belief.
  • The latter leads us to believe that, after the fact, the occurrence of an event was obvious.

Many investors tend to be overconfident, believing that they are better able to perform a certain action or task than they actually are. For others, the fear of making losses can lead to inaction or an over-reaction when confronted with the potential for an investment to lose value.

Students of behavioural finance would say that these are not uncommon and are natural responses because we are humans and not machines. The key is being able to identify and understand these prejudices and biases and to set them aside to focus on the basics.

Perhaps more importantly, the need to maintain self-esteem may prevent us from learning from our previous mistakes. In an attempt to rationalise this we will often attribute our failures to chance rather than to poor decision making.

Did you recognise any of the biases described above in your past behaviours?

Arming ourselves with this self-awareness can make us better equipped in the future to hold them in check, and might help us make more informed and rational decisions.

If you did see something of yourself in this article, understand that the best way to avoid the pitfalls of human emotion is to have a reasoned investment strategy and to stick to it.

As individuals we should try to resist the urge to believe that our information and intuition are better than others in the market. Particularly as we are competing with computers and institutional investors with better data and more experience than ourselves.

Important Information

Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise. No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed herein.

Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions. Any views expressed within this report are our in house views as at April 2019 and should not be relied upon as fact and could be proved wrong. The information contained in this document has been derived from sources which we consider to be reasonable and appropriate. This document may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent. 

Lloyds Bank plc. Registered Office: 25 Gresham Street, London EC2V 7HN. Registered in England and Wales, number 2065. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority under number 119278.

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