Putting investors on the analyst’s couch

As investors, I suspect we secretly like to think ourselves as a little bit more sensible than the average person, and maybe a bit more rational.

We dont live only for today, pretending theres no tomorrow. We realise we will get old, and that it makes sense to set aside money to better meet that future. Our heads are out of the sand and looking at the far horizon.

Nor do we stash our cash in savings accounts paying peanuts for interest, simply because we cant stand the ups and downs of the stock market. We understand that, over the long term, equities have been wealth-generation machines for those who can put up with their fluctuations.

Maybe we invest in index funds because weve read the data that says the average person whether a DIY investor or a fund manager cant beat the market. Instead, we focus on keeping costs low so we retain the biggest proportion of those long-run returns from shares for ourselves.

Or maybe we pick stocks but we use our analytical minds to find better value companies and shun the fads and manias. Like Warren Buffett, were sober investors in solid businesses not gamblers at the casino.

Its a mad world

But should we feel so smug? Sure, we investors are more realistic than a spendthrift banking on lottery tickets to bail out their old age, but are we really Spock-like paragons of intellectual virtue?

Of course not were as nutty as anyone else, but in our own ways.

In fact, a whole branch of economics has come to the fore over the past few decades dedicated to unpicking the irrational forces lurking inside our oh-so-rational minds.

Nobel prize-winning economists such as Daniel Kahneman and Robert Shiller have used a mixture of experiments and data to prove investors are not the super-wise beings that classical economics once painted them as.

On the contrary, were a bundle of contradictions and biases that, at the extreme end, have a tendency for what psychologists call magical thinking, meaning we believe in relationships or outcomes that cannot be justified by reason.

Weighty burden

A good example is anchoring. This is the tendency of investors to focus on a particular price of an asset perhaps the price they first encountered or the price they paid to own it when assessing its future value.

Why would I call this magical thinking? I think its best explained by way of illustration.

Again and again, investors will tell you theyre holding some share theyve lost money on until they break even. Yet the price they happened to pay in the past for the share is irrelevant in terms of whether continuing to own it is the best investment now available to them.

The market doesnt know or care what price you paid for your shares. All that matters is the future value of the company (or more precisely the future cash flows it will generate) compared to the market price today.

Focusing on the price you paid for your shares makes no more sense than studying the bones of a chicken you roasted on Sunday for clues.

Yet we anchor on prices so routinely we dont even notice were doing it.

Three of a kind

Behavioural economists have revealed many other distortions like this in our thinking. Here are three more:

Loss aversion we humans hate losses more than we love gains. In practice, this means we over-value investments where we believe the downside risk is limited while under-valuing those with higher potential rewards. Kahneman demonstrates this to his students with a coin toss where they lose $10 if its tails. Logically they should accept $20 as the win for it being a heads, but in practice they want more than $20.

Confirmation bias this describes how we tend to look for evidence that supports our position. The latest GDP figures are strong, so we applaud our decision to buy shares in a bank. But when worse-than-expected unemployment data is released, we whistle to ourselves and decide our fingernails need a trim.

Recency bias people extrapolate whats happened lately to presume it will continue indefinitely. Recency bias is why people are so gloomy about shares after a crash, when theyre actually being offered investments they know they want to own at a much cheaper price than before. But why buy, they think, if shares are just going to keep falling? The same thing happens in bull markets, only then it is presumed the good times will keep on rolling.

Let off for bad behaviour

Are you now blushing at the memory that in 2012 you bought shares in a small-cap oil explorer because such shares had risen strongly for years (recency bias), you kept ignoring warnings that an oil price over $100 was unsustainable to instead concentrate on stories about how peak oil was upon us (confirmation bias), didnt sell your shares when they halved before halving again (loss aversion) and are now determined to hang on until they finally get back to the price you paid for them (anchoring) after conveniently multi-bagging for you?

Well, dont be too hard on yourself. As I said, these behavioural glitches are universal and weve all done similar. Once were aware of them we can try to be on our guard, but I doubt you can be an active investor without continuing to fall foul now and then.

Instead of getting angry, though, maybe you can get even? Look out for situations where other investors may be falling prey to their emotions and faulty thinking.

Just remember that as the physicist Richard Feynman said: The first principle is not to fool yourself. And you are the easiest person to fool.