Behavioural economics has revealed many ways that investors — and investment advisors — can make mistakes or be fooled by things that are not what they seem. These are just five of a long list of biases and errors that can undermine our best intent.
These behaviours are summarised from the work of Nobel Prize winning psychologist Daniel Kahneman, who is one of the fathers of behavioural economics. Reading any of Daniel’s works will make an advisor a better advisor.
Very few people are what Kahneman calls ‘well calibrated’ when it comes to their confidence in their predictions, even when it is in their interest to make an accurate forecast. He suggests that when someone says they are 99% confident, it should be assumed that the real probability is 85% (or less).
You also see the overconfidence bias at work when you ask people about how good they are at driving, compared to others. Eighty percent of drivers believe they are ‘above average’.
Adding optimism to overconfidence produces a powerful compound effect. Optimism leads people to underestimate the possibility of bad outcomes, while overestimating the possibility of positive outcomes.
People are very bad at recalling after an event, what they believed before it. Kahneman’s example is to try to recall what you thought the probability of the last central bank action was the day before it occurred.
Most people cannot do this — they can’t reconstruct their prior belief after the event, so many are honestly deceived when they exaggerate their earlier estimate of the probability that the event would occur.
At other times, the hindsight bias manifests as totally unexpected events appearing virtually inevitable after the fact.
Kahneman warns that this bias poses a particular threat for financial advisors, as hindsight can ‘… turn reasonable gambles into foolish mistakes in the minds of investors’. After a stock has fallen, he explains, its fall appears to have been inevitable – so why didn’t the advisor suggest selling it earlier?
Overreaction to Chance Events
Humans are pattern-seeking creatures and we can be easily fooled by finding them where they do not actually exist!
Kahneman considers two coin-toss sequences of heads (H) or tails (T)
Most people consider the random pattern in option 2 to be the more likely to occur than the apparently systemised pattern in option 1. In reality, the probability is identical for both sequences.
In finance, people often see trends where none exist and end up taking actions based on an erroneous impression. One study analysed hundreds of thousands of share trades and found that where people sold one stock and quickly bought another, the stock they sold outperformed the stock they bought by 3.4% in the first year.
Purchase Price Reference Point
Investor A owns a share they bought for $100, while investor B owns the same share but paid $200. Yesterday the share-price was $160 — today it is $150. Is person A or person B the more upset?
Kahneman’s research discovered that people ‘feel’ the pain of losses more than the pleasure of gains, so investor B is feeling the most hurt. Their loss is increasing, while investor A has only suffered a reduction in gains.
Being anchored to a purchase price underpins the disposition effect, where an investor sells a stock that has gone up but keeps the one that has fallen.
Regret and Risk-taking
Most people feel more regret about things that they did do than things they did not do. But one study has shown that people who regret investment opportunities they missed tend to take more subsequent risks than people who regret attempts that failed.
Risk-takers were also found to downplay the role of luck in both positive and negative outcomes, believing their judgment played a more important role.