9684608

This month we continue with our “Bias mini series” for a couple of reasons, firstly they are a much larger factor in ultimate investment returns than “current market activity” and secondly they fit squarely in the “things you can exert control over”, unlike European debt packages and US fiscal cliffs.

Not that these issue aren’t important, it’s more that not much has really changed in reality and so there’s no real “new” news.  Accordingly, we continue to monitor rather than react.  In the meantime, let’s brush up on our behavioural science so that when it is time to make a change, we’re more likely to make the right one.

This month we’ll look at of couple of examples which have definitely been overdone in recent years, Anchoring and Restraint Bias.

Anchoring Bias

Anchoring bias is the tendency to rely too heavily, or anchor on a past reference or one piece of information when making a decision. There have been many academic studies undertaken on the power of anchoring on decision making. Studies typically get people to focus on a totally random number, like their year of birth or age, before being asked to assign a value to something. The studies show that people are influenced in their answer, or anchored, to the random number that they have focused on prior to being asked the question.

From an investment perspective, one obvious anchor is the recent share price. Many people base their investment decisions on the current share price relative to its trading history. In fact, there is an entire investment school of thought (called Technical Analysis, an amusing term in itself) that bases investing on charting share prices. Unfortunately where a share price has been in the past presents no information as to whether a stock is cheap or expensive.

We prefer investment managers who base investment decisions on whether the share price is trading at a discount to an assessment of intrinsic value and with no regard as to where the share price has been in the past. They also have little regard to the prevailing share price in deciding to invest the time to research a new investment opportunity. Share prices continually change and it’s important to have a range of well researched investment opportunities so that can be acted on an informed basis when prices move below the assessment of intrinsic value.

This is of also important when making changes to existing investments.  Many investors are loath to sell “at a loss” and will therefore prefer to wait until an investment recovers to at least match what they paid for it.  In reality, what price was paid is irrelevant to the future prospects of an investment.  Sometimes a an investment is unreasonably sold off and given the drop, it now represents the best opportunity for future gains as this mispricing is corrected.  Other times, this drop is more than warranted and can in fact be a warning of even worse returns to come.  Similarly, strong returns since original purchase can make some investors reluctant to sell investments.

Consider the following example:

From this information alone, stock XYZ has been the “better” investment.  The temptation therefore is to sell ABC and buy more XYZ.  The reality is however that this information provides no insight into the future prospects of either stock and is therefore worse than useless as it is distracting.  This tendency to “bury the red” by selling off apparent losses is often regarded as removing “underperforming” investments, when more often than not, there is simply a timing difference.

Imagine one year later, ABC has increased 15% whilst XYZ remains the same.  We now have:

ABC is still showing a net loss over the entire period and XYZ continues to be the standout.  The reality is however that over the last year, ABC provided the entire portfolio’s return and was therefore the standout for last year.  Most standard “Valuation” or “Portfolio Position” reports fail to capture this and as such are potentially misleading for return and evaluation purposes.  The best measure of performance is “Internal Rate of Return (IRR)” which measure the return on the actual capital invested during a specific period.  Similar risks in these situations are Loss Aversion and Hindsight Bias, which we will discuss in a future article.

Restraint Bias

Restraint bias is the tendency to overestimate one’s ability to show restraint in the face of temptation. This is most often associated with eating disorders. Most people are wired to be “greedy” and want more of a good thing or a “sure winner”. For many people, money is the ultimate temptation. The issue for many investors is how to properly size an investment when they believe they have identified a “sure winner”. Many investors have come unstuck by overindulging in their “best investment ideas”. Many seasoned investors loaded up on financials during 2007 and 2008 in the belief that they became more and more compelling as their share prices fell. This was then followed by similar losses in property in many areas throughout the country, again most notably where the largest recent gains had been made.  This was despite the lessons of the “dot com” experience less than 10 years earlier.

In our experience, “sure thing” investments are exceptionally rare and many investments are very sensitive to changes in assumptions, particularly macroeconomic assumptions.  In order to overcome our natural tendency to buy more and more of our best ideas we hardwire into our process restraints or risk controls that place maximum limitations themes, investments or combinations of these which we consider to carry aggregation risk. Better to lament the not having enough on a good idea than having had too much on a bad one.

The benefit of risk controls to mitigate the human greed tendency is well captured by the quote from Oscar Wilde: “I can resist everything except temptation”

Inspiration and content for this series has been obtained from a number of sources in particular, Magellan Asset Management and Platinum Asset Management.
Matt Battye

Matt Battye

CEO, Financial Adviser

Analysing what can seem to be like complex issues, Matt is effective in using analogies to better explain scenarios and truths to the rest of us. This is what Matt enjoys – educating clients on the truths and debunking the commonly held (wrong) view.

Share This