“Buy low and sell high” is a phrase that many people have heard. So why do many investors do the opposite?
A US study by the Dalbar Group provides some interesting thoughts. Their 2008 Qualitative Analysis of Investor Behaviour (QAIB) study showed that for the 20 years ending December 31, 2007 the average equity mutual fund investor achieved an annualized rate of return of 4.48 per cent, compared with the average equity mutual fund rate of return of 11.81 per cent over that same period.
How did it happen? Investors sold after markets declined, and usually reinvested a few years after markets recovered. They were out of the market at the wrong time and it cost them dearly.
Why did it happen? Because we’re human and sometimes we make decisions that are influenced by a range of subconscious factors.
Imagine that you are a physician working in an Asian village, and six hundred people have come down with a life-threatening disease. Two possible treatments exist. If you choose treatment A, you will save exactly two hundred people. If you choose treatment B, there is a one-third chance that you will save all six hundred people, and a two-thirds chance that you will save no-one. Which treatment do you choose, A or B?
If you chose A, then you’re in the majority – this is what most people pick.
Now, consider a slightly different problem.
You are a physician working in an Asian village, and six hundred people have come down with a life-threatening disease. Two possible treatments exist. If you choose treatment C, exactly four hundred people will die. If you choose treatment D, there is a one-third chance that no-one will die, and a two-thirds chance that everyone will die. Which treatment do you choose, C or D?
Most people choose D. They’d rather risk losing everyone than settle for the death of four hundred.
Have another look at the two examples. Whilst they’re worded differently, option C is the same as option A, and D is the same as B. So why do we pick different options just because they were worded differently?
Nobel Prizes and investor behaviour
Daniel Kahneman won a Nobel Prize for his work in behavioural finance. One of the things he spoke about was a process called ‘framing’. This occurs sub-consciously when we’re faced with two choices and we make our choices based on our perception of the risk involved. We usually prefer a small, sure gain to a larger, uncertain one. But the problem is that sometimes we’re not very good at understanding the risk, and therefore make wrong choices. The example above illustrates how easy it is for this to happen.
Kahneman also highlighted the concept of risk aversion – showing that the pain of losses have twice the psychological impact as equivalent gains.
How do you perceive things?
Our mind is affected in many ways by our environment and a lot of the influence happens sub-consciously. It’s important to understand how the concepts of framing and risk aversion affect you.
Many people look at their recent investment experience and expect that to continue. When markets are returning 20% you expect that will continue forever. When they drop 20%, there’s a feeling that the negative returns will continue forever, despite evidence to the contrary.
The important thing is to make choices for the long term good that remove as much of your sub-conscious bias and emotion as possible.
The downside of hindsight
Many people now are going through periods of regret about their finances. “If only we’d switched to cash”, “Why did we invest that lump sum into our super” and “Why didn’t I see this coming” are comments I’ve heard a lot over the past year.
Hindsight is a great thing to learn from, but it’s pointless feeling bad about choices that were perfectly good decisions at the time, made on the basis of all the information and knowledge you had.
It’s okay to have regrets about what has happened – that’s natural – but it’s no good to feel like you should have seen it coming.
Summary
We don’t make decisions that are 100% based on pure logic. Emotion comes into every decision we make. It’s important to understand how much of our thinking is influenced by our environment and our recent experiences, and to ensure we don’t have a subconscious bias because of that.