When it comes to investing, irrational behaviour abounds. Whether you manage your own money or have someone else manage it for you, usually the biggest drivers for decision making are emotion. Just like the excitement of feeling you know something in Wheel of Fortune when you buy a vowel, people make truly irrational decisions about how, where and when they put their money to work. That is why having a written investing plan is so critical for success. It will highlight what behavior you want to avoid by implementing a set of rules to circumvent irrational decisions.

Some Background

Before we analyze irrational investing behaviours and their outcomes it is probably necessary to define where this falls into place. We can look at irrational behaviour both from a managed and DIY (do it yourself) perspective. Both are equally damaging to your portfolio and certainly can be mitigated if not prevented. As Dick Davis, author of “The Dick Davis Dividend – Straight Talk on Making Money from 40 Years on Wall Street” states, ”We are predisposed to fail, but not predestined”. Meaning, our human characteristics make failure something that will occur but we can take steps to change our course and make better decisions.

The field that studies irrational behavior has a deep rooted history dating back to 1896. More recently, the idea of Behavioural Finance was introduced by two psychologists, Daniel Kahneman and Amos Tversky through their various studies beginning in 1973. Feel free to do your own reading.

http://en.wikipedia.org/wiki/Behavioral_finance

The most common conclusions about the behaviour of people are that they have a tendency to be overconfident and a desire to avoid regret. These characteristics manifest themselves in a variety of ways that often have a costly effect on our investment decisions.

Now Is The Time … I Just Know It

Greed and fear are two of the most powerful emotions that humans experience. William Bernstein, a retired neurologist, author and money manager explains that one of the  reasons investors embrace risk (Globe & Mail April 20, 2010) lies in two tiny bundles of neurons called the nuclei accumbens situated just behind each eye. These neurons serve as the brains “anticipation centre”. He states that these neurons “light up whenever we anticipate something good happening. That something good could be food, social contact or making a lot of money in the market”. Bernstein states the problem is that recently,  investors’ nuclei acumens’ are lighting up like Christmas trees because they see a 76% advance in the S&P 500 since the low of 2009. In other words, they have a heightened state of anticipation about “making money” and subsequently are much more willing to take on risk by getting back into the market.

If you look at recent (past 5 years) market activity, it would seem obvious that the worst time to get into the market was July of 2008 and the best time was two years ago in March 2009. The markets were at their respective top and bottom. Yet if you analyze inflows and outflows of money, especially within the managed world of equity-based mutual funds, you will find almost the exact opposite. Investors shifted about $200-billion out of U.S. equity funds between September of 2008 and March 9, 2009 when the the S&P 500 Index ultimately fell by 58 per cent from its peak. But that same money didn’t go back into the market before it rallied to 90 per cent of its original level. And that doesn’t even consider how much money went into the market from January of 2007 to September of 2008. I remember speaking with people in August of 2008 who had just been advised to put all of their RSP into equity-based funds only to see 40% of it evaporate within 4 months.

Bernstein goes on to say that “the primary mistake most investors make is they confuse the economic outlook with returns going forward. In fact, the best forward-looking returns are obtained when the economy looks the worst, and the worst returns are obtained when the economy looks the best”.

Quite the paradox, we buy at market tops and sell at market bottoms. To learn to do the opposite – or to override our own brains – would help us significantly, but alas we have thousands of years of evolution telling us differently. Historically we had to make split-second decisions for survival. However investing isn’t about the next 5 minutes. It’s about a much longer term and somehow our brains aren’t wired for that.

Behaviour #1 – Overconfidence

Confidence is a good trait. But overconfidence is an interesting dynamic. You have probably heard of the professor who asks his students “How many of you think you are above average intelligence?”, or “How many of you think you are a better than average driver?”. Of course the list can go on but the results are usually similar.

Somewhere around 75% of people believe they are better than average. Statistically that is impossible but in their reality it is a matter of perspective. In investing terms, it probably shows up in statements like “I have got a sure thing” or “This stock can’t go down”. Remember Nortel? How many people thought that at $200 it was still going to go up and, after repeated reverse splits, at $2 that it couldn’t go any lower? Ever watch people who gamble? How many people will actually collect their winnings when they are up? Obviously Las Vegas isn’t in business because the house loses. That gambling mentality is often pervasive with investors. It usually takes one of these forms:

• A particular outcome of a random event is more likely to occur because it has happened recently (“run of good luck”)
• A particular outcome is more likely to occur because it has not happened recently (“law of averages” or “it’s my turn now”) Translation – My stock will continue to go up, or I should get in now because it’s at the lowest point. Second translation – I didn’t sell when I should have and now I am down so I best just stick with it because eventually everything turns. You could look at the opposite in a similar light as well.
• A particular outcome is less likely to occur because it has happened recently
• A particular outcome is less likely to occur because it has not happened recently.

Although each of these statements may be true to an extent within a certain context they also tend to create overconfidence. Overconfidence usually leads to under-performance primarily because there wasn’t a good strategy to begin with to make the decisions. When it comes to your money, it would seem more important to apply good logical criteria with systematic and well thought out entry and exit points corresponding to the goals you have within your investing plan. Financial success is not just about the next decision.

Behaviour #2 – Hindsight Bias

A major cause of overconfidence is Hindsight Bias. Hindsight bias is a particular way of looking at things to make sense out of the world. We pretend something is more predictable than it actually is and when it occurs we say we knew it was going to happen. Kind of a post justification. However, this trait also tends to have us forget the bad decisions we make and subsequently we lose some of our perspective. Let’s consider the following. You have two options to work with your money.

1) Put all of your investments in the previous year’s best performing assets

2) Put all of your investments in next year’s leading asset class

This might be an extreme example but the results are interesting. Just because something was the best performing, does not at all mean it will continue to be. The mutual fund industry is a classic example of this. Most of the advertising that investors see is the “best performing” funds available to be purchased because in the investment business, one sells track record. Unfortunately, many of these funds do not stand the test of time and will eventually disappear or get merged because of poor results. But by then they have garnered widespread support because of the short-term track record and have accumulated hundreds of millions of dollars in people’s retirement money.

Consider this as well. During the past 30 years, the index from among the S&P 500, the TSX Composite and the MSCI World Index that has performed the best one year has only managed to take the top spot the next year less than half the time. Of course the contrarian approach didn’t outperform either. During that same timeframe, picking the worst performer among the three in anticipation that it would provide great returns the following year, only produced about 7% annually. Not bad but not exceptional.

So instead of an all or nothing approach, ensure you have a strategy that allows you some diversification, a decision-making process that takes into account good logic and a contingency plan when the world changes. (Just like it did again last week in Japan)

Behaviour #3 – The Herding Effect

The Herding Effect simply described is the tendency for people to follow the actions of a larger group whether good or bad. The Herding Effect is usually influenced by what is loud and in your face. Ever had to choose a new restaurant for the first time? There are many factors that could go into your choice. Quality of food, value for money, food preferences, location of the restaurant, etc., but what about how full the restaurant is? Many of us would assume that if a restaurant is full it must be good and therefore we should go to it. Although this may be true, it might not at all meet our other more sound criteria.

In the investing world, this herding effect can come across as “They know something I don’t so I should get on board”. Usually it is accompanied by overoptimistic and sometimes outrageous predictions. Remember the dot com era? How many people jumped into the market towards the end of the ‘90s and into 2000. The best money was made at the beginning (next years leading) of the cycle but because “everyone was buying tech stocks, you better too or you will get left in the dust”. By the time the average person hears about it, or wants to get involved, the investment is overheated and positioned for failure.

Even as recently as 2008 when the economy was booming, oil was $147 a barrel poised to hit $300, and energy, mining and agricultural stocks were at their premium. How many people jumped into specific stocks or mutual funds related to these sectors only to watch their money disappear faster than air out of a popped balloon.

Behaviour #4 – Aversion to Loss

No one likes to take a loss if they don’t have too. We all have been to that garage sale where someone has placed ridiculous prices on their old “junk” items. It’s a bit of an oxymoron. Clearly having a garage sale is to get rid of stuff you don’t want so why put prices on it that won’t let it sell? Dan Ariely in his book “Predictably Irrational” points out that our aversion to loss is a strong emotion that causes us to make bad decisions. He states that “as soon as we begin thinking about giving up our valued possessions, we are already mourning the loss”. In fact given two equal choices, one expressed in possible gains and the other expressed in possible losses, people would choose the former almost all the time. We perceive pleasure much more readily than we perceive pain.

If we look at our investment choices we tend to sell our winners because who doesn’t feel good about proclaiming victory (remember you knew it was going to go up). But we hold onto our losers because of our sense of pride and the offsetting feelings of regret (I made a mistake) and loss (it will come back to even). A well-defined strategy together with proper risk management and emotional control will go a long way to helping us make better decisions. The development and implementation of a plan will get you there.

Conclusion

Whether you chose to give your money to someone else to manage or take greater control and manage it yourself, understanding the impact of irrational behaviour will go a long way to creating better results. As Dick Davis points out:

• For every professional opinion about a stock, the market, the economy, interest rates, inflation, and so on, there will always be an exact opinion by someone equally or more knowledgeable.
• There is no such thing as an expert on the market. The market is perverse,  contrary, illogical, random, enigmatic, and unfathomable. The market is not black or white but gray!

Your financial temperament will trump financial IQs. You don’t need to have a financial degree or be a financial professional to be a good investor.