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Your Portfolio and Behavioural Finance

Portfolio Lesson 5.10: Recognising irrational behaviour is easy, but correcting it is another matter entirely

Morningstar 21 July, 2010 | 12:30PM

Finance professors aren't the first group of people you'd approach for investment advice. Academics seem to know more about how to study money than to make it. And so much academic advice seems to squeeze the fun out of investing. Countless academics advise not trying to actively choose stocks but to simply index the market. And countless investors reject that advice.

But if you end up in the same room with a couple of behavioural-finance economists, listen up. They study the psychology and behaviour of investors to see where they make mistakes. If you learn to spot and correct these mistakes, it may mean greater profits. And if you spend enough time with these people, you may even learn how to profit from the mistakes of other investors.

This lesson will explore what behavioural finance is and cover the common behaviour that gets in the way of achieving even better investment results.

The Origins of Behavioural Finance
The academic field of finance has long had a behavioural side. One of the classic examinations of irrational investor behaviour, Extraordinary Popular Delusions and the Madness of Crowds, dates back to the 19th century. In the 1930s, legendary economist John Maynard Keynes and value-investing maven Benjamin Graham emphasised the effect of investors' emotions on stock prices. More recently, money manager David Dreman published The New Contrarian Investment Strategy in 1982, which argued that investors could outperform by not following market fads.

None of those works drew explicitly upon psychological research, though. One of the first academic papers to do so was "Does the Stock Market Overreact?" by Richard Thaler and Warner De Bondt in 1985.

Some insights behavioural finance has to offer read like common sense, but with more syllables. It's no secret, for example, that many investors will focus obsessively on one investment that's losing money, even if the rest of their portfolio is in the black. That's called loss aversion. Other behaviour, though, is more subtle, more difficult to spot, and harder to correct.

Overconfidence
Overconfidence refers to our boundless ability as human beings to think that we're smarter or more capable than we really are. One study found that 90% of the automobile drivers in Sweden rated themselves above-average drivers. Moreover, when people say that they're 90% sure of something, studies show that they're right only about 70% of the time.

Such optimism isn't always bad. Certainly we'd have a difficult time dealing with life's many setbacks if we were die-hard pessimists.

However, overconfidence hurts you as an investor when you believe that you're better able to spot the next Microsoft than another investor is. Odds are, you're not. (Nothing personal.) Studies show that overconfident investors trade more rapidly, because they think that they know more than the person on the other side of the trade. Trading rapidly costs plenty, and rarely rewards the effort.

To avoid overconfidence in your own investing, document and review your investment record. It's easy to remember your one stock that gained 50% in a single day, but records may reveal that most of your investments are under water for the year.

Paying attention to the odds would help, too. Statistically, even if you live in Sweden, you're more likely to be an average automobile driver than an above-average one. Similarly, there's a 50% chance that the seller is getting the better deal in every trade, and a 50% chance that the advantage accrues to the buyer. The more trades you make, the more likely that your success rate will trend toward 50%.

Mental Accounting
If you've ever heard someone say that they can't spend a certain pool of money because they're planning to use it for their vacation, you've witnessed mental accounting in action. Most of us separate our money into buckets--this money is for the children's education, this money is for our retirement, this money is for the house. Heaven forbid that we spend the house money on a vacation.

Investors derive some benefits from this behaviour. Earmarking money for retirement may prevent us from spending it frivolously. Mental accounting becomes a problem, though, when we arbitrarily divide the components of total return: income and capital appreciation. Many investors feel that they can't spend capital appreciation--that's principal--but they can spend income.

Ironically, investors can erode their principal in a quest for generous income streams. Take a bond fund that pays a high dividend, but generates a negative capital return. Your original investment would shrink, not grow, every year. Eventually, your dividends would shrink as well. That's because a bond fund's yield is nothing more than a percentage of its asset base. So even if a fund maintained, say, an 8% yield, the amount of its dividends would fall if its capital returns were negative, eating away its asset base.

The best way to avoid the negative aspects of mental accounting is to concentrate on the total return of your investments, not simply one dimension of their return.

Anchoring
Ask Londoners to estimate the population of Manchester and they'll anchor on the number they know--the population of the capital--and adjust down, but not enough. When estimating the unknown, you cleave to what you know.

Securities analysts often fall prey to anchoring. They get anchored on their own estimates of a company's earnings, or on last year's earnings. Say an analyst had previously forecast that a firm would post quarterly earnings of 50p per share, and the firm posted actual earnings of 60p. The analyst would then raise his forecast for next quarter's earnings, but not by enough.

For investors, anchoring behaviour manifests itself in an unwillingness to part with laggard investments. Often investors will cling to an investment waiting for it to "break even," to get back to what they paid for it. You may cling to subpar investments for years, rather than dumping them and getting on with your investment life. It's costly to hold onto losers, though, especially in a taxable account: If you realise a loss, at least you can use it to offset realised gains.

Some behavioural finance types recommend that you ask yourself: Would I buy this investment again? And if you wouldn't, why are you continuing to own it?

Other Behaviour To Avoid
Some other behaviour that stymies your investment results may include:

Representativeness: This is a mental shortcut that causes you to give too much weight to recent evidence--such as short-term performance numbers--and too little weight to the evidence from the more distant past. As a result, you'll give too little weight to the real odds of an event happening.

Regret: You may not distinguish between a bad decision and a bad outcome. You'll feel regret after a bad outcome, such as a stretch of weak performance from a given stock, even if you chose the investment for all the right reasons. Regret can lead you to make a bad sell decision.

Fashions and fads: You may feel comfortable investing with the crowd, as in following a market guru or buying a popular fund. Such behaviour can lead to fading performance or inappropriate investments for your particular goals.

Of course, it's easy to recognise irrational behaviour; correcting it is another matter entirely. Still, if the insights of behavioural finance lead you to at least think twice before committing an irrational act of investing, that's a start.

Catch up on previous Investing Classroom lessons in our Learning Centre.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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