The Hidden Influences of Your Brain: Part 2 – Investment Errors
posted on November 6th, 2015 by Bellmont Research Team
This is the second of 5 posts that will show you how to use insights about your brain to become a better investor. In the first post we followed the story of Mark & Meg as they purchased a car, and discussed a number of hidden decision-making biases that they were exposed to. In this paper we will examine some common investment errors that result from underlying behavioural biases.
We will continue to follow the story of Mark & Meg. While they are a married couple and share the family income and expenses, they have quite different risk preferences and perspectives on investing. Both had independently accumulated some assets before they met, and so have continued to manage their investments separately. Mark is a self-directed share investor, managing a portfolio of individual stocks. Meg mostly prefers to invest in managed investments.
Mark is considering a new investment opportunity that he recently read about in the financial press – Ivoprotein Industries. It’s a small listed company* that has developed a gene-based therapy that reduces appetite and can help the overweight. It’s already received FDA approval in the US and has signed up a distribution agreement with a major pharmaceuticals company. Sales are growing rapidly (albeit off a small base) and, given the global obesity epidemic, the potential market size is huge. Ivoprotein’s share price has risen from 5.5c just 18 months ago to 48c today.
There is a collection of biases that are likely to predispose Mark to buy Ivoprotein. Firstly, there is a lot to like about Ivoprotein, and a lot to be excited about. An innovative new product; high sales growth; high share price growth; an expanding market opportunity (pun intended); a salient and easily understood investment story. These characteristics are likely to engage the reward pathways in the emotional centres of Mark’s brain, making him feel good about the stock. In the complex and uncertain world of share market investing, feeling good about something can be an easy shortcut when deciding what to buy. However, unfortunately, good feelings don’t necessarily predict good performance!
Secondly, as we saw with assessing Audi’s maintenance record (see part 1 of this series), we are predisposed to a range of information processing errors. These may lead Mark to extrapolate Ivoprotein’s share price growth, sales growth and commercial successes into the future. However, due to a phenomenon called “regression to the mean”, other things being equal, Mark should expect Ivoprotein’s stellar run to revert to closer to industry average performance for equivalent biotech stocks.
Thirdly, based on the success rate of other promising biotech companies like Ivoprotein, we would expect there to be a very small chance that Ivoprotein will go on to become a highly profitable global drug company. However, just like the small chance of winning the lotto, we tend to weight these small probability events more heavily in our decision-making process than we should.
The effects that lead Mark to buy Ivoprotein are common to many “growth” stocks, and have far-reaching implications for investment markets and strategies. We will explore these in later posts.
While Mark watches the stock market daily, Meg tunes in to financial matters only occasionally. There are too many other things going on in her life, and it isn’t a passion of hers like it is with Mark. However, it seems to her that whenever she reads something about financial matters it is bad news: there is a war starting somewhere or a central banker causing market to fall. Meg is going to sell some of her Australian Equities Fund to help pay for her new car. To reduce her risk, she’s wondering whether she should convert more of her fund to cash.
Like Mark, Meg is subject to both emotional and information processing biases. A major cause of Meg’s thinking is likely to be her “loss aversion”. Loss aversion means, in part, that we fear losses roughly twice as much as we enjoy equivalent gains. Every piece of negative news increases Meg’s anxiety, making her increasingly predisposed to sell as the market falls. Of course, selling after market falls is the opposite of the conventional wisdom – meaning that Meg is at risk of selling at the worst time and being under-invested during a subsequent market rebound.
Meg is also subject to the “availability bias”. In theory, a fully rational investor should process all available relevant information before making an investment decision. Clearly this is not realistic, particularly for Meg given her competing priorities. We are therefore likely to act on information that comes to our attention. In Meg’s case, the information she relies on is what is presented to her via mainstream news channels. As a result, it has been filtered to reflect perceived news-worthiness, perhaps biasing it towards sensationalist (negative) events. We will examine strategies to help overcome these effect in later posts.
Like Meg, Mark needs to free up some cash to help purchase the new car. He also needs to fund the acquisition of Ivoprotein. To do this he is thinking of selling his investment in Tintop industries*. Mark bought Tintop for $2.33 a few months back. Since then it’s done well – rising to $2.81, netting him a healthy 20% gain. “I’ll lock in my profit,” Mark says to himself.
While it may be completely necessary for Mark to sell something to fund his car purchase and other investments, choosing Tintop suggests Mark may be subject to the “disposition effect”. The disposition effect is the tendency to sell winners (ie investments on which we have made a gain) and hold onto losers. It is a function of two underlying effects: “mental accounting” and “loss aversion”.
Traditional finance theory suggests that a fully rational investor should view each investment in the context of its contribution to overall portfolio risk and its contribution to achieving the their long-term financial goals. However, many investors consider each investment in isolation. This is a form of mental accounting. Given the complexities of investment markets and our finite brain capacity it serves a useful purpose. It simplifies investment decisions to a manageable level. However, it leaves us exposed to making individual stock selection decisions that do not improve overall portfolio performance.
Secondly, “loss aversion”. We discussed part of this effect with Meg’s decision to sell some of her Australian Equities Fund. Mark is experiencing a different aspect of it. Mark’s gain makes him feel good. However, the bigger the gain, the less additional satisfaction he derives. Conversely, were that gain to evaporate, his positive feeling would diminish rapidly. Studies suggest that investors consciously or subconsciously envision this scenario, and anticipate the regret they would feel if they didn’t sell when they had the chance. With diminishing pleasure from further gains, and large potential regret from not selling, off-loading Tintop may fell like a natural thing for Mark to do.
Unfortunately the disposition effect leads to bad outcomes for investors – leading them to sell stocks (winners) that continue to rise, and to hold stocks (losers) that continue to fall. It also has contributes to the momentum effect, which we will explore in later posts.
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Simon Russell, Director, Behavioural Finance Australia
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