The Irrational Investor - Why We Act That Way

The markets finally seem to be heading in the right direction-up. After taking a deep sigh of relief, we're now asking ourselves why we didn't invest more while the markets were low. Time and again we've been advised to buy low and sell high, so why is this so difficult to do?

Anyone who has tackled financial economics in college will recall professors filling blackboards with algebraic symbols that purported to explain precisely how financial markets work based on the capital asset pricing model, the efficient-market hypothesis. These theories, however, had a key flaw: they assumed that people make financial decisions with the rationality and precision of an astrophysicist calculating a moon launch. But if we investors are so rational, why are we not all rich?

According to a new academic discipline called Behavioural Economics, investors tend to be foolish, emotional and illogical. As we emerge from one of the worst markets of all time, let's examine some of the classic ways investors fool themselves and fall behind their goals.

The Gambler
Suppose you took $1,000 to Las Vegas and won $2,000 on your first bet. Chances are you will mentally divide the money into two portions: the hard-earned cash you squeezed from your paycheque and the easy money you won at the roulette table. You continue to spend the first wad relatively cautiously, but throw the second wad around the room with abandon. If we were economically rational, we would value the gambling win as much as the money we work for, but in reality that's not how we react.

A form of mental accounting known as"framing" may influence how investors will respond to a correction or a high-performing investment. Framing applies arbitrary yardsticks and time periods to assess whether you are winning or losing. Instead of using logic and depositing money in a low-risk investment, the gambler in us wants to put the"found" money in the high-risk investment with the best short-term performance.

Asymmetric Loss Aversion
A stranger offers to flip a coin: heads, you have to pay him $500; tails, he'll pay you an agreed-upon amount. How much would the potential win have to be to make the game attractive? Common sense says anything over $500 tilts the wager your way. But if you're like most people, you're not tempted by anything under $1,000. You may be affected by a condition known as "Asymmetric Loss Aversion", whereby losing money feels twice as bad as making money feels good. In other words, the value of a potential win in a fifty-fifty game of chance has to double the cost of a loss before we take the gamble.

This phenomenon prevents some investors from ever taking money from safe investments because they simply cannot envisage the risk/reward opportunity of another type of investment. This way of thinking can cause even greater losses in the long run. Consider that over the last eight months, many investors poured money into money markets, GICs and other safe harbours, while in the previous year they poured money into the equity markets at twice the price.

Clueless Anchors
Smart investors understand how futile it is to try to predict markets. The rest of us find the uncertainty so hard to tolerate that we impose patterns where none exist. We create anchors-apparently logical rules of thumb-to help deal with issues about which we have no clue. Random anchoring has long been a favourite pastime of Wall Street analysts. Without it, how could they fix a price for those Internet stocks that had no earnings or any imminent hope of success? Their thinking went this way:"Amazon.com trades at about 20 times sales, so software.net should go public at, say, 14 times." Left unexamined is whether Amazon at 20 times sales made economic sense. These anchors cause investors to value investments based not on prudent measures, but on the relative value compared to other investments, even though they may also be overvalued. Many investors are using these anchors now. Instead of taking advantage of the great value in many securities, they are sticking hard and fast to their original investments- refusing to sell until they have broken even-while other investment opportunities do even better.

Overconfidence
A key benefit from mental gymnastics such as anchoring is a pleasant, if inappropriate, sense of confidence and control over our surroundings. Of course, confidence is not all bad. It gives us the energy and optimism to deal with challenges, even if it makes us ineffective at estimating the odds of success. Since investing means putting off the pleasure of today's wealth in the expectation of gaining more to enjoy tomorrow, optimism is plainly a prerequisite. However, it can be costly if it gives you the illusion that you can determine the future.

A brand of overconfidence that many investors succumb to is finding patterns in what may actually be a series of random events. People tend to think that any mutual fund manager who excels five years in a row can do no wrong. In reality, given the number of fund managers, a few are bound to have exceptional returns. However, this detail fails to deter investors who are confident that they have discovered a pattern of superior performance and throw their money into the current top funds. Unfortunately, these managers do not repeat their success any more often than their peers.

Investors often follow the latest trend, sometimes unloading good steady investments for a new hot investment that leads to regret. Choosing a good manager takes much more research than looking back at track records. But many investors fail to determine if a manager is suitable for the mandate of their portfolio.

The Rear-View Visionary
One reason we are convinced of our ability to forecast economic events is that we firmly believe we have done so (or could have done so) in the past. We're just not good at recalling risk assessments made months ago.

Our overconfident but inept predicting helps explain one of the more profitable loopholes in classic financial economics. Studies have shown that out-of-favour stocks-those with low prices relative to earnings, sales, and cash flow-tend to perform better over time than high-priced glamour stocks. One reason is that overconfident investors tend to project continued rates of growth for glamour stocks indefinitely. Expectations for value stocks, on the other hand, are low so that decent earnings tend to be a pleasant surprise.

The Rational Approach to Investing
As we have repeatedly advised, there are no shortcuts to investment success. The best way to invest is simply to:

• take a long-term approach
• diversify based on time frames and objectives
• rebalance on a regular basis

If you think behavioural economics may have affected you over the last eight months, perhaps you should review your portfolio.