What Kind of Investor Are You? An Interesting Look at the Behavioural Drivers of Investing

by Dominique Schuh

At its final board meeting for 2017, the Reserve Bank Board decided to leave the cash rate unchanged at 1.50 per cent.  Conditions in the global economy have improved over 2017. Labour markets have tightened and further above-trend growth is expected in a number of advanced economies, although uncertainties remain. Growth in the Chinese economy continues to be supported by increased spending on infrastructure and property construction, although financial conditions have tightened somewhat as the authorities address the medium-term risks from high debt levels. Australia's terms of trade are expected to decline in the period ahead but remain at relatively high levels.

Wage growth remains low in most countries, as does core inflation. Equity markets have been strong, credit spreads have narrowed over the course of the year and volatility in financial markets is low. Long-term bond yields remain low, notwithstanding the improvement in the global economy. Recent data suggest that the Australian economy grew at around its trend rate over the year to the September quarter. The central forecast is for GDP growth to average around 3 per cent over the next few years. Business conditions are positive and capacity utilisation has increased. The outlook for non-mining business investment has improved further, with the forward-looking indicators being more positive than they have been for some time. Increased public infrastructure investment is also supporting the economy. One continuing source of uncertainty is the outlook for household consumption. Household incomes are growing slowly and debt levels are high. Employment growth has been strong over 2017 and the unemployment rate has declined. Inflation remains low, with both CPI and underlying inflation running a little below 2 per cent. The Bank's central forecast remains for inflation to pick up gradually as the economy strengthens. The Australian dollar remains within the range that it has been in over the past two years. An appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast. The low level of interest rates is continuing to support the Australian economy. Taking account of the available information, the Board judged that holding the stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.

Behavioural Investing

When it comes to money and investing, we're not always as rational as we think we are – which is why there's a whole field of study that explains our sometimes-strange behaviour. Where do you, as an investor, fit in? Insight into the theory and findings of behavioural finance may help you answer this question. A lot of economic theory is based on the belief that individuals behave in a rational manner and that all existing information is embedded in the investment process. This assumption is the crux of the efficient market hypothesis. But, researchers questioning this assumption have uncovered evidence that rational behaviour is not always as prevalent as we might believe. Behavioural finance attempts to understand and explain how human emotions influence investors in their decision-making process. You'll be surprised at what they have found.

The Facts

In 2016 Dalbar, a financial-services research firm released a study entitled "Quantitative Analysis of Investor Behaviour", which concluded that average investors fail to achieve market-index returns. It found that in2016, the S&P 500 returned an average of 11.96% for the year, while the typical equity investor achieved only 7.26% for the same period – a startling 4.7% difference! Why does this happen? There is a myriad of possible explanations.

Regret Theory

Regret Theory deals with the emotional reaction people experience after realizing they've made an error in judgment. Faced with the prospect of selling a share, investors become emotionally affected by the price at which they purchased the share. So, they avoid selling it as a way to avoid the regret of having made a bad investment, as well as the embarrassment of reporting a loss. We all hate to be wrong, don't we? What investors should really ask themselves when contemplating selling a share is, "What are the consequences of repeating the same purchase if this security were already liquidated and would I invest in it again?" Regret theory can also hold true for investors when they discover that a share they had only considered buying has increased in value. Some investors avoid the possibility of feeling this regret by following the conventional wisdom and buying only shares that everyone else is buying, rationalizing their decision with "everyone else is doing it". Oddly enough, many people feel much less embarrassed about losing money on a popular share that half the world owns than about losing on an unknown or unpopular share.

Mental Accounting
Humans have a tendency to place particular events into mental compartments, and the difference between these compartments sometimes impacts our behaviour more than the events themselves. Say, for example, you aim to catch a show at the local theatre, and tickets are $20 each. When you get there you realize you've lost a $20 note. Do you buy a $20 ticket for the show anyway? Behaviour finance has found that roughly 88% of people in this situation would do so. Now, let's say you paid for the $20 ticket in advance. When you arrive at the door, you realize your ticket is at home. Would you pay $20 to purchase another? Only 40% of respondents would buy another. Notice, however, that in both scenarios you're out $40: different scenarios, same amount of money, different mental compartments. Pretty silly, huh? An investing example of mental accounting is best illustrated by the hesitation to sell an investment that once had monstrous gains and now has a modest gain. During an economic boom and bull market, people get accustomed to healthy, albeit paper, gains. When the market correction deflates investor's net worth, they're more hesitant to sell at the smaller profit margin. They create mental compartments for the gains they once had, causing them to wait for the return of that gainful period.

Prospect/Loss-Aversion Theory
It doesn't take a neurosurgeon to know that people prefer a sure investment return to an uncertain one – we want to get paid for taking on any extra risk. That's pretty reasonable. Here's the strange part. Prospect theory suggests people express a different degree of emotion towards gains than towards losses. Individuals are more stressed by prospective losses than they are happy from equal gains. An investment adviser won't necessarily get flooded with calls from her client when she's reported, say, a $500,000 gain in the client's portfolio. But, you can bet that phone will ring when it posts a $500,000 loss! A loss always appears larger than a gain of equal size – when it goes deep into our pockets, the value of money changes. Prospect theory also explains why investors hold onto losing shares: people often take more risks to avoid losses than to realize gains. For this reason, investors willingly remain in a risky share position, hoping the price will bounce back. Gamblers on a losing streak will behave in a similar fashion, doubling up bets in a bid to recoup what's already been lost. Investors often make the mistake of chasing market action by investing in shares or funds which garner the most attention. Research shows that money flows into high-performance managed funds more rapidly than money flows out of funds that are underperforming.

Over-/Under-Reacting
Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic during downturns. A consequence of anchoring, or placing too much importance on recent events while ignoring historical data, is an over- or under-reaction to market events which results in prices falling too much on bad news and rising too much on the good news. At the peak of optimism, investor greed moves shares beyond their intrinsic values. When did it become a rational decision to invest in shares with zero earnings and thus an infinite price-to-earnings ratio (think dotcom era, circa the year 2000)? Extreme cases of over- or under-reaction to market events may lead to market panics and crashes.

Overconfidence
People generally rate themselves as being above average in their abilities. They also overestimate the precision of their knowledge and their knowledge relative to others. Many investors believe they can consistently time the market. But in reality, there's an overwhelming amount of evidence that proves otherwise. Overconfidence results in excess trades, with trading costs denting profits.

Conclusion
Behavioural finance certainly reflects some of the attitudes embedded in the investment system. Behaviourists will argue that investors often behave irrationally, producing inefficient markets and mispriced securities – not to mention opportunities to make money. That may be true for an instant, but consistently uncovering these inefficiencies is a challenge. Questions remain over whether these behavioural finance theories can be used to manage your money effectively and economically. That said, investors can be their own worst enemies. Trying to out-guess the market doesn't pay off over the long term. In fact, it often results in quirky, irrational behaviour, not to mention a dent in your wealth. Implementing a strategy that is well thought out and sticking to it may help you avoid many of these common investing mistakes.