Emotional Habits – The psychology of investing

Welcome to a special look at a feature produced by our investment team in the latest issue of our quarterly magazine, True Insight. This week will be looking at the psychology of investing, the investing ups and downs you could be making without knowing it.

For all the modern analytical devices that today’s investors can surround themselves with and for all the cool-headed rationality investors like to think they employ, we remain human.

As human beings, our behaviour and decisions are influenced by psychology. We all have strongly-ingrained biases that can serve us well in our day-to-day lives but can have the opposite effect when considering the financial markets.

Not surprisingly investor behaviour has been analysed and found to fall into two camps; cognitive (decisions relating to statistical, information processing or memory errors) and emotional (reasoning based on intuition or impulse which results in action based on feelings).

No one likes to incur a loss. It’s very easy to put off or delay an investment decision waiting for a better moment, we might be too keen to realise a small profit and miss out on a big one or we might be greedy and wait too long before selling, in which time the investment falls.

Of course, if it goes up it’s due to our skill and if it goes down it’s bad luck!

Let’s take a look at some of the classic behavioural traits investors exhibit.

Inertia and default

Inertia and Default, or the “status quo” bias in which people prefer to do nothing instead of making a change, is often found with Defined Contribution (DC) pension plans.

For those of us with a DC plan, how often have you reviewed or adjusted your fund selection or contribution rate since the plan’s initiation? Do you know if you are on track to reach your retirement goal?

Evidence shows that the majority of plan participants do not review or change their asset allocation or contribution rate despite time, circumstances and goals changing.

Availability bias

Our thinking can be greatly influenced by what is personally most relevant, recent or dramatic. For some, the 2008 global financial crisis continues to be at the forefront of minds when investing, despite it occurring over ten years ago.

A monumental event indeed, but this was a once in a generation event, with the last financial crisis on a similar scale being the Great Depression of 1929-39. Those investors discouraged to invest by the 2008 market turmoil, preferred to keep cash in the bank. Safe? Not from inflation.

If at the end of 2008 you had placed £50,000 into a UK savings account, by the end of 2018, after adjusting for inflation, it would have been worth £48,808. Over the same period, £50,000 invested in global equities would have risen to £124,986 after inflation.

Prudence Trap

Behavioural biases are not only exerted by investors; economists, analysts and even investment committees can be guilty too.

Economists are often required to make forecasts, for example what the oil price might be in a year’s time. Say the oil price is currently $65 and consensus is for it to fall to $55 but one economist believes it will fall to $35, they may be tempted to temper their forecast and bring it closer to the consensus, say to $45.

In this way the prediction doesn’t look as extreme, but they will still receive the same amount of credit should the oil price fall to $45 as they would if it fell to $35. This is known as the Prudence Trap.

Loss aversion

Let’s say you buy Apple shares for $100 on the basis of speculation that the new iPhone will be the best yet.

However, after launching, the share price falls to $70 with consumers disappointed by the new features. What do you do? Do you sell or hold?

Loss aversion occurs when investors hold, fearful of realising a loss even though rational analysis suggests the shares should be sold. Investors who exhibit loss aversion feel the pain of a loss approximately two to two and a half times as much as the joy of an equivalent gain!

Conclusion

One of the ways in which the investment industry has sought to avoid these behavioural influences, which can affect us all, is to build computer based, systematic strategies which are programmed to buy or sell under specific conditions.

Of course, these are not without their faults and idiosyncrasies either. As ever, in some circumstances there is a strong case for the emotionless logic of a systematic computer strategy: sometimes though, it makes sense to adopt the subjective judgement of human intervention. That’s why we employ both within the True Potential Portfolios.

*Assumption: Average UK Savings rate taken from swanlowpark.co.uk, UK CPI used as the measure for inflation – source: Office for National Statistics

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