In order to survive as a species, people have evolved to be both risk averse and loss averse, to be fearful of such possibilities. But these attributes serve us poorly as investors. To be a successful investor, one needs to overcome that fear and to take calculated risks.
Humans have also adapted to survival through staying together and developing the so-called herd instinct. This gathering allows us to build societies, fight predators and fulfil sociological needs. But, again, following the crowd fails to bring investment success. Rather this leads to investment mediocrity and even failure.
Many theses have been written on our behavioural predisposition which prevents us from making sound investment decisions with hundreds of factors being described and proposed as shortcomings preventing us from effective investing and wealth management.
There are really only four biases that matter most and there are effective measures that we can put in place to address them:
1. Overconfidence: We think we are luckier than the average, smarter than the average, more attractive than the average. While the Dunning-Kruger effect may relate to incompetent folk having the unrealistic belief that they are smarter and more capable than they really are, most people suffer from overconfidence in some respect.
This may result in a misrepresentation of the past (remembering only the good times), thinking they are “one situp from dating a supermodel”, to believing they can beat the market. Being overly optimistic makes us think we can forecast more accurately than we actually can and be better stock pickers than we are. Of course, no-one can actually forecast.
2. Familiarity bias: This occurs when investors confuse what they know with what’s safe or desirable, remaining in their comfort zone. They tend to expect higher returns and underestimate the risks of an investment because they are familiar with it. And in misjudging the risk, they fail to manage it appropriately, overlooking the most obvious tool: diversification. Familiarity bias can lead to investing in stocks too close to home, employer stocks and even companies that you respect and like, but which do not have a positive future.
3. Limited attention bias: This bias means that investors are basing decisions on information which has grabbed their attention rather than the basis of probability. People confuse vividness or ease of recall with the likelihood of something transpiring. For example, after 9/11 people became scared of flying. However, there are far more road accidents and deaths than ever occur from flying, even as a result of the extraordinary incidents that took place on that frightful day.
Because tracking all the stocks available is a mammoth task, it’s easier to base investment decisions on the information that the media opts to shine a spotlight on, or buying a “stock tip” that someone has recommended, while many worthy investment options may go unnoticed. This same bias doesn’t apply when selling stocks because, apart from short sellers, one is generally selling only stocks one owns.
4. Loss aversion: This is perhaps one of the strongest emotional biases that people have, where they focus on gains and losses relative to risk rather than on returns relative to risk. Some may perceive the stock market to be too risky to invest in although, since 1925, 95% of rolling 5-year returns on the JSE were positive meaning that, in the longer term, investing in shares is really safe.
If you listen to your emotions, however, it can be hard to invest when the market has fallen and equally difficult to sell when it has risen. It’s tempting to exit the market when it is collapsing around you and everyone else is selling, but that it exactly when you should be doing the opposite. And the same is true when the market is running and becoming overheated.
It is clear that our evolutionary human frailties rail against us when trying to accrue and manage wealth. But there are clear and deliberate steps that we can, and must, take to protect ourselves and our future generations.
Addressing behavioural biases
1. Overconfidence: Make sure that your plan includes diversification. Because winning stocks rotate and it’s not possible to be 100% accurate regarding which will be the outperforming equities at any stage, diversification is the best strategy to protect you from downturns and offer you the best investment opportunities each year.
Then, before implementing your plan, have a “pre-mortem” – look at what can possibly go wrong and aim to risk manage it. Also, know exactly what you are buying before you buy it. Know its business model, know and understand the investment thesis and be sure that you are satisfied with its outlook.
2. Familiarity bias: If you only buy stocks that you know you are severely limiting your investment universe and your portfolio can suffer from a lack of diversification. The first step is to accept that familiar is not necessarily safe. Then make a conscious effort to expose yourself to new options and become familiar with stocks you don’t currently know.
It can help to procrastinate a little, to sleep on your decision for a night and only then pull the trigger. Of people who are in a rush, 82% just go with what they know. If you slow the decision down and take more time, that comes down to 56%.
3. Limited attention bias: This bias exists because the media has an effect on your trading activities. Once you recognise this, you can research and evaluate stocks that are outside of the usual suspects. Avoid blindly following tips and taking investment shortcuts and aim to tune out media noise when looking at investments. Even mimicking a successful investor’s portfolio or faithfully investing based on recommendations from others is not advisable – it is always preferable to do your own research. Decisions regarding your money need to be rational and well thought through.
4. Loss aversion: By taking emotion out of the equation you will be able to deal with loss aversion more effectively. One way is to use trading rules. By developing a set of rules to govern your trades and then applying them dispassionately, you will be able to take those extremely hard decisions that will ultimately preserve your portfolio value.
Using an advisor is another way to remedy to this bias. Using impartial support to counter the tendency to become emotionally involved can mitigate the risks associated with it and add objectivity. An experienced advisor can ensure that investors receive the best possible advice and protect them from active trading that results in the “investor behaviour penalty,” helping them stick to their investment plan.
At Citadel, we aim to provide investors with peace of mind. Working together with an advisory partner, and understanding your own risk appetite as well as your behavioural biases and inclinations, you can feel more confident of your investment plan and your investment decisions. Knowing the potential pitfalls in advance and taking positive steps to avoid them will put you on the best path to build a lasting legacy.