Investing over the last two years has been extremely difficult, for both DIY and professional investors. We have all been inundated with negative news (think case numbers, worst case scenarios for outbreaks, lockdowns etc) which affects our ability to make optimal investment decisions.
A recent study by Griffith University and Iress (2021) examined the switch decisions by Australian Superannuation fund members during the COVID pandemic. The key findings of the study included that over 70% of investors had a negative impact, when they changed investment options. These studies illustrate when making investment decisions, we can be our worst enemies. However, the field of Behavioural Finance (BF) is providing evidence as to why investors make poor investment decisions.
BF is the application of psychology to financial decision making. By allowing psychological biases and emotions to affect investment decisions, investors can do serious harm to their wealth. Investors who are prone to behavioural biases will take risks they don’t acknowledge and experience outcomes they did not anticipate. Investment decision making is a complex process, and often we use heuristics to assist us in making decisions.
Heuristics are rules of thumb or ‘short-cuts’ to process information which are used due to information overload. Behavioural Economists initially applied psychological experiments in financial decision-making settings. A few ‘short-cuts’ to potentially help you become aware of some behavioural biases and you protect you from making common investor mistakes.
Representativeness is the tendency of investors to make decisions based on stereotypes where perhaps none exist. This short-cut can be detrimental to investors on a number of fronts. For example, investors may forecast future earnings of a company, using the short histories of high earnings growth observed in the past. These estimates are then used to value the company and consequently, lead to overpricing. In this scenario, the investor is failing to consider the high earnings growth could be just due to chance. If future earnings are lower than forecasted, the share price could fall considerably.
The same can also be said of price data or charts. Investors try to find patterns or trends from which they can benefit. And, often investors only identify trends when they are already well established. Consider the negative news and price charts during the COVID-19 episode in March 2020. Many investors anticipated further bad news and were well and truly extrapolating consecutive losses into a longer-term trend. The representativeness heuristic makes decision making easier, however, it might cause you to draw wrong conclusions that can be detrimental to your wealth.
The availability bias occurs when you make a decision based on an example, information or recent experience that is readily available to you. A decision based on this pretext may not be the best example to inform your decision. The information that is easily brought to mind is assumed to be more frequent. Information that is more difficult to bring to mind is assumed to be less frequent.
The availability bias is a dangerous heuristic that can deter you from attaining your investment goals. Some examples of the negatives are below:
- Investors with availability bias are more likely to invest more in companies/funds they regularly hear about. For example, consider large-cap stocks dominating business headlines as opposed to mid-small cap stocks.
- Investors with availability bias are more likely to overreact to market news. In the case of initial negative news on a company or market event, investors suffering from availability bias extrapolate this news into a ‘long-term view’. For example, a negative quarter of earnings growth implies that the company is ‘bad’ and a sell decision for the investor.
To avoid the availability bias, it is best not to track your investment too frequently. The more an investor pays attention to the current market price of their investment, the more likely they will make a premature and detrimental decision to their overall wealth.
At eInvest, our expert investment partners in Perennial Value and Daintree Capital maintain a disciplined investment processes with the goal of delivering on their stated investment objectives. Each of the teams are well versed in handling vast and rapid amounts of information on markets, economies, companies and government policies to ensure investment decisions are made as objectively as possible.
In 2022, eInvest will continue our series on BF to help investors avoid common pitfalls when making investment decisions. By being aware of your behavioural biases, eInvest hopes to contribute on your investment education journey, and on delivering a positive investment experience to you.
Disclaimer: Please note that these are the views of the writer, Zaffar Subedar PHD, Investment Specialist at eInvest and is not financial advice. To find out how to invest in our active ETFs, visit here. The product disclosure statement and more can be found at www.einvest.com.au. If you’d like to keep learning further, please feel free to follow any of our socials listed below.