What type of investor are you? Are you as rational as you think you are? When it comes to investments we often behave quite strangely and to our own detriment. The field of study that focuses on this important area is behavioural finance and understanding the basics might just help you to avoid some classic traps.

Are Investors Rational?

A lot of investment theory is founded in the belief that investors are rational and absorb all existing information and this is then reflected in fair market prices. That the market is efficient and that attempts to outsmart the market just don’t work. This view is the foundation of the Efficient Market Hypothesis and the basis for index investing, a topic on which we have previously commented.

Recent research suggests that investors are not rational and make decisions that are influenced by behavioural biases with their actions more often affected by emotions.

Investors who have experienced market downturns are likely to acknowledge that while financial markets are inherently cyclical; these cycles are often exacerbated by investor emotions.

In this article we examine some of the common investor biases. Perhaps you can recognise a little bit of yourself in some of these examples.

Regret Theory

This theory deals with the emotional reaction people experience after realizing they’ve made an error in judgment.

They are reluctant to admit they have made a mistake such as picking a bad or poorly priced share and they attempt to avoid facing the reality of poor decisions often by holding on to investments too long which can increase their losses.

This feeling is often mitigated where the investor has made a poor decision that everyone else has made. If they are buying shares that are popular then they are less likely to feel regret. Consequently they seek to avoid regret by following the herd and buying shares that everyone else is buying.

Rivalry

The element of rivalry can have a strong influence on investor decisions. This is where the value of gains or the pain attributed by losses is affected by how we perceive our competitors are doing.

“I know I have lost money but as long as I have done better than my cousin then I don’t feel so bad” or “I can make money from a bank term deposit but everyone else seems to be getting a better rate from some of these higher risk companies I see advertised in the paper. I don’t want to miss out.”

Anchoring

Anchoring is where investors use a single piece of information as the basis of all analysis about the value of that investment. An example is the price they purchased an investment for. They see this as the right price and future decisions are based around this. “I’ll hold this investment until I get my money back”.

Anchoring often blinds investors to other important information. For example where circumstances affecting the company have changed or where they paid too much in the first place. This can blind investors to the possibility that there may be better places now to allocate their funds.

Overconfidence

The overconfident investor tends to have too much confidence in their own abilities. They regard themselves as above average and are often too quick to attribute investment successes to their skills rather than to market trends.

They are particularly vulnerable in boom markets which tend to re-enforce their belief, leaving them poorly prepared for market corrections.

The overconfident investor believes they can successfully time the market when in reality evidence clearly shows this is near impossible to do. They tend to make decisions without adequate advice or research, which can threaten their long-term strategy. In addition they often participate in an excess number of buys and sells which erode investment performance.

Mental Accounting - Compartmentalisation

Compartmentalising our thinking can lead to decisions that are not always rational. Take the situation where you may be getting irate with a taxi driver in Mexico over a 20 peso fare when he quoted 15 pesos. When you think that you’re getting stressed over 50c an amount less than your usual tip back in Australia it doesn’t make much sense.

Another example is the doctor who attended a conference in the US at a time when the US dollar was at an all time high. All the prices were expensive but the doctor took comfort from the fact that he had received a fee for a talk he gave at the conference that easily covered the cost of the trip. Had he received the same fee for the talk a week earlier in Australia he would not have been so comforted about the high US dollar.

This type of thinking can also affect our investment decisions. For example where we have purchased an investment for $10,000 and after 2 years it had doubled to $20,000. In the next 3 months it fell to $13,000. A 30% gain over 2 years is still a good return but we feel let down because of where the investment had risen to and may be reluctant to sell it until it recovers it’s former highs, even though there may be better places for us to invest that money now.

Loss-Aversion Theory

People fear loss more than they value gain, even if the value of the loss or gain is the same.

Loss aversion theory explains why investors hold on to losing stocks: people often take more risks to avoid losses than to realize gains. For this reason, investors willingly remain in a risky stock position, hoping the price will bounce back. Gamblers on a losing streak will behave in a similar fashion, doubling up bets in a bid to recoup what’s already been lost. So, despite our rational desire to get a return for the risks we take, we tend to value something we own higher than the price we’d normally be prepared to pay for it.

Over/Under-Reacting

Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic amid downturns. They tend to over or under react to market events which results in prices falling too much on bad news and rising too much on good news.

This type of behaviour causes stock prices to go way beyond their fair value in times of optimism and way below their fair value in times of pessimism, resulting in asset bubbles and crashes.

Conclusion

People are imperfect processors of information and are subject to bias, error and perceptual illusions. Even the canniest of investors can be caught out by the unpredictability of human behaviour. So what can you do to navigate through these traps?

• Be aware. Understanding some of these behavioural biases can help you avoid the obvious.
• Question your decisions. Are you making a choice based on emotion or informed financial analysis?
• Stay informed. Read the financial press to keep abreast of what is happening.
• Maintain a well-diversified portfolio. Diversification can assist in avoiding investment biases by helping you to see your portfolio as a whole, and part of a long term strategy.
• Seek advice. Professional financial advice can help keep your emotional biases in check offering a balanced perspective based on reasoning and research.

Andrew Condell

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Recent turbulence in investment markets has caused many investors to rethink their plans for the future. It’s a timely reminder that the unexpected is never too far away and that plans often have to be changed or moderated to deal with changing circumstances.

Many who were considering retirement have chosen to defer their departure date while some in retirement have re-entered the employment market in some form or have plans to do so.

Those younger investors that have only known boom times have had the opportunity to learn from the experience a downturn brings. The prospect of redundancy, falling incomes and asset values has caused many to rethink their spending patterns, their debt levels and adjust their lifestyles.

These strategies can enable investors to weather difficult times and position themselves to stay on track in achieving their longer term objectives.

Pay down debt and tighten the budget.

A reassessment of spending patterns can make a big difference to your financial position. Australian households carry significant amounts of personal debt. Reducing expenditure allows more funds to repay debt, or to meet living costs if your income has fallen recently. For retirees this enables them to draw less from their investments providing valuable time for portfolios to recover as markets recover.

Restructure loans

With interest rates at comparative lows it’s an opportune time to restructure higher interest loans and consolidate credit cards. This can have a big impact on cashflow and allow more funds to meet living costs if your income has fallen. Alternatively the additional cashflow can be directed to the accelerated repayment of loans.

Delay retirement

Deciding to remain in the workforce for a few more years may make an enormous difference to your super balance on retirement and could also enable you to access a range of benefits you might otherwise forgo.

Pension Bonus Scheme

The Pension Bonus Scheme provides a tax-free lump sum upon retirement to people who defer claiming the Age Pension (for up to five years) and continue to work. The current maximum amounts for each year are as follows:-

 

The amount of your bonus will depend on how much Age Pension you are entitled to receive upon claiming both the pension and the bonus together, and how many bonus periods you have accrued (up to a maximum of five years). For further details of eligibility call us.

The Pension Bonus Scheme will close to new entrants from 20 September and will be replaced by the proposed Work Bonus Scheme (WBS). The WBS will be paid fortnightly and will be calculated by a relaxation of the Centrelink income test whereby only 50 per cent of the first $500 in gross fortnightly income is counted. This will result in an extra $125 per fortnight (maximum payment) in age pension being paid to eligible recipients.

This WBS bonus will be payable even if you continue to earn an income from paid employment and, unlike the Pension Bonus Scheme, it’s also possible to stop work for a period of time, causing the bonus to cease, and then recommence work at a later date, once again triggering the bonus payment.

Start a transition to retirement strategy

You can delay retirement by commencing a transition to retirement pension. This strategy allows you to reduce your working hours to part time supplementing your lost income by drawing a tax effective or tax free pension (if you are 60 or over) from your super monies.

Alternatively if you want to stay in the workforce full time you can use this strategy to increase your salary sacrifice super contributions and supplement the reduced income by drawing a pension from your super monies. This strategy has significant tax advantages.

Maximise your pension entitlement

If you are in receipt of the age pension make sure you keep Centrelink up to date with the value of your investments. If your investments have fallen in value in recent times or if your income has fallen, as is the case for most investors, make sure you tell Centrelink. This is to ensure that Centrelink take the latest values into account in calculating your entitlements.

Rejoining the workforce

This is sometimes an option for those in retirement. The benefits include supplementing your income to meet living costs. In addition this allows you to draw less from your investments providing valuable time for portfolios to recover as markets recover.

If you do recommence employment and you are in receipt of Centrelink benefits make sure you notify Centrelink. In relation to your existing superannuation or pension investments it is important to note that rejoining the workforce will not change the preservation status. You will still retain any rights to access your existing investments that existed beforehand.

Conclusion

It is certainly heartening to see investment markets recover in recent times. However, uncertainty and changing circumstances are things we can be sure of encountering in the future. Keeping in mind the cyclic nature of things and adopting a flexible approach is key in navigating our way through.

Andrew Condell

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The share market recovery continues to provide strong returns for investors with six months of solid returns. This is on the back of encouraging signs both domestically and internationally.

Australian equities as measured by the ASX 200 gained over 40% from the lows of early March until late August. These very strong gains can be attributed to continued better than expected economic data from Australia and overseas. Corporate earnings results have also surprised on the upside providing added momentum to the equity rally.

 

Australia is proving rather resilient compared to many other OECD countries and this has resulted in upward revision of economic forecasts. This is thanks in part to the large budget surpluses that have been spent, aggressive easing of monetary policy by the Reserve Bank of Australia and the continued economic prosperity of some of our major Asian trading partners.

 

China is obviously the economy that is having the greatest impact on our prosperity. The Chinese economy continues to have strong demand for resources, much of which can be easily sourced from Australia. China’s appetite is so great that they now purchase 80% of our iron ore exports and almost 30% of our coking coal.* The Chinese Government has been in the enviable position of having enormous budget surpluses in recent years which they now have been able to access and redistribute to the economy by means of spending on infrastructure and growth in domestic credit.

That Australia appears to have avoided a recession does not mean that it is plain sailing from here on in. There are large imbalances in the economy which need to be dealt with. Bankruptcies are yet to peak and bad debts are expected to rise as unemployment remains relatively high and elements of corporate Australia fail to adapt to current market conditions. The government stimulus packages will dry up in several months time severely testing consumers retail spending and the housing market. Compounding this will be the inevitable increase in official interest rates. Business investment continues to be weak and will need to strengthen to provide for more durable economic growth.

In the US, positive signs are appearing. US Retail sales rose 0.6% during June. Sales of cars also rose, thanks mainly to the “Cash for Clunkers” program which offered owners of old cars and trucks $US3,500 or $US4,500 to exchange an old vehicle for a new, more fuel-efficient vehicle. It is claimed that this accounted for almost 700,000 new car sales in the US. Sales of new single-family homes rose 9.6 % from June to a 433,000 annual pace, the highest rate in 10 months. US unemployment has also improved with the official rate falling to 9.4%.

Europe’s largest economy - Germany, is showing signs of slowly recovering from its worst recession in decades. The results of a recent business survey indicate that business confidence had increased for a fifth consecutive month. Other recent news that surprised on the upside was positive economic growth in the second quarter.

In Japan the news is not so rosy with the jobless rate increasing to 5.7%, which exceeded market expectations. The export sector has been the hardest hit, with exports falling for a tenth straight month in July. Demand from China remains strong however strong growth from the USA is not expected for some time.

The outlook for investment markets over the coming 12 months is positive, but perhaps not as strong as we have experienced over the past 6 months. The continued optimism is based on expectation of continued signs of economic growth although stock markets may have raced ahead a little too fast. Major downside risks are diminishing and investors are becoming more risk averse. This improvement in investment markets is not expected to be smooth as there continues to be significant global issues which need to be resolved.

*Van Eyk Investment Outlook Summary August 2009 Page 8

Brendan Gallagher

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