| I am sure most of you have experienced that sickening feeling when an investment goes wrong – instead of beating yourself up for being stupid, it might help to understand some of the entrenched emotions and biases that led you to make the bad decision in the first place. Behavioural Finance is a new-ish field in the science of investing, and more than any other factor – asset allocation, market trends, high fees – can have a negative impact on your long-term wealth. Many of these biases are entrenched over decades and go right back to the way you were brought up. Having said that, once you know them and stare them in the face, perhaps it will make your future investing journey more comfortable, if not for you, then for your wealth advisor.  Anchoring Bias: This occurs when individuals rely too heavily on initial information when making decisions. For example, anchoring to the purchase price of a stock and not considering its current value or future prospects. FOMO is obviously in play here, and there are plenty of meme stocks out there that should act as a warning bell. There is another bias, not listed here, that will also play into this, and that is cognitive dissonance – the need to drag others into your narrative to bolster your belief in having done the right thing – common in many purchases and certainly in investments too. Good asset managers pay far more attention to the long-term prospects of a share than what it is doing right now – but that requires a certain skill set that you might not have. If an investment has been a runaway success – ask yourself whether this can be sustained. During the pandemic, the markets were flooded with these get-rich-quick stocks on the back of Covid-19 – without much thought as to how long this would last. The graph below is the poster child of the pandemic – Cathy Wood’s ARKK investment. It took almost exactly 2 years to go from the start to the finish of the bubble, and almost exactly 9 months to burst. There may be nothing wrong with some of ARKK’s underlying investments but clearly, the price investors were willing to pay was driven more by narrative than facts.  Source: Investing.com  |
Confirmation Bias: People tend to seek out information that confirms their existing beliefs or opinions and ignore information that contradicts them. This can lead investors to overlook potential risks or dismiss alternative investment options. Locally, the Steinhoff share is probably an example of this. Investors ignored the warning bells from the German Tax Authority in 2015 (when it was trading at around R60 a share) and continued to hype it up to R95 a share in 2016 where it slid quite markedly until the bombshell in December 2017. (Perhaps professional investors were taking profits and selling to the ‘retail ’ market?) Overconfidence Bias: Overestimating one’s abilities or knowledge can lead to excessive risk-taking and poor investment decisions. Emboldened by some wins, investors may believe they can outperform the market consistently, leading to a lack of diversification or inappropriate asset allocation. This bias is closely related to the Dunning-Kruger effect. Confidence is one thing, but do you really want to sit at the peak of Mount Stupid?  Source : https://www.wallstreetmojo.com/dunning-kruger-effect/ . There are certainly occupations and professions out there that have a low intellectual barrier to entry, asset management and financial advice are not among them.  Loss Aversion: The tendency to strongly prefer avoiding losses over acquiring gains. This can lead investors to hold onto losing investments for too long in the hope of recouping losses, rather than selling and cutting their losses. This bias is often ingrained from childhood or early adulthood and is extremely difficult to shift. If you identify with this bias – the best thing that you can do is partner with an advisor who can save you from yourself. Having a DIY approach if this is one of your biases will be extremely stressful. Assets do not have feelings. They don’t care that you bought them at their peak; they are now old, mouldy, and non-performing. No amount of cajoling is going to bring them back to their former glory. The only way to give that wealth new life is to unlock it by recommitting the capital to other ideas which are aligned to your long-term investment goals. Herding Behavior: People often follow the actions of the crowd, assuming that others possess more information or insight. This can result in asset bubbles or market crashes as individuals buy or sell en masse without fully understanding the underlying fundamentals. In a word… FOMO. There is a train wreck streaming to your device in real-time – DJT (Trump’s Truth Social Platform) on the Nasdaq.  Recency Bias: Giving more weight to recent events or experiences when making decisions. Investors may be overly influenced by the most recent market trends or performance, leading to short-term thinking and impulsive decisions. In South Africa, at the moment, this is centering around the fixed-income market v stocks. Fixed income has probably reached a peak with repo at 8.35% and fixed govt bonds yielding north of 10% – but that has only been in play since mid-way through 2023. The pandemic is about 4 years old which is when Jibar reached the bottom at 3.3% and yielding an average of 5.2% for 2020 (around about inflation). SA 3 Month JIBAR (Source: Reserve Bank)  As a matter of fact, for those that hold money market assets, you have not had it this good since 2009… that is 15 years ago! For long-term assets, remember you can have your cake and eat it but this has to do with owning the correct local and offshore equities in combination with fixed income which should include the money market. Endowment Effect: People tend to value items they already own more than equivalent items they do not own. This can lead investors to hold onto assets simply because they own them, even if better investment opportunities are available. Again, this is likely to be a bias and preference that has become entrenched over the years.  Sunk Cost Fallacy: This is the inclination to continue investing in a project or asset because of the resources (money, time, effort) already invested, regardless of the likelihood of success. This can lead to irrational decision-making as individuals are reluctant to accept losses. Individuals are not the only ones who fall foul of this bias – companies do it all the time – pouring more and more money into a project that is clearly failing. Unfortunately, there are some well-publicised examples of where this approach actually worked. Amazon took 9 years to turn a profit. If you were one of those long suffering Amazon shareholders you deserve the gains that have subsequently come your way. It is fair though to say that initial investors were probably driven by something more than money. They saw Amazon’s transformative power and took a risk on its ability to solve for the future. Familiarity Bias: Preferring to invest in familiar assets or companies, even if they may not offer the best potential returns or diversification benefits. This can lead to an overly concentrated portfolio and increased risk. Just because you know a company’s product, or even use it, it doesn’t mean it is a good investment.  Emotional Bias: Emotional states such as fear, greed, or excitement can cloud judgment and lead to impulsive or irrational decisions. It’s essential for investors to remain disciplined and objective, particularly during periods of market volatility. In summary therefore, one of the most important roles of a financial advisor ( which I went into in much more detail in this blog: https://www.moneyweb.co.za/financial-advisor-views/top-nine-reasons-why-financial-advisors-are-more-valuable-than-you-think/ ) is to act as a buffer between your wealth and your emotions and biases so that your investments can achieve the goals you want them to achieve. If you’d like to subscribe to our free podcasts and newsletter, or give me another topics you’d like to see a blog on, drop me an email.  Articles and Blogs: Why do I need a financial advisor? NEW Costs Fees and Commissions The NHI and what do do about it New-Normal for Retirement? Locking-In Interest rates – The inflation story Situs – The Myths and Reality Tax Residency – New Rules new headaches Are retirement annuities dead A new look at retirement Offshore investing – an unpopular opinion Cobie Legrange and Dawn Ridler, Rexsolom Invest, Licensed FSP 45521. Email: cobie@rexsolom.co.za, dawn@rexsolom.co.za Website: rexsolom.co.za, wealthecology.co.za |