Which is the better investment – one with a 50/50 chance of a large profit and a 50/50 chance of an equally large loss, or one with a much lower probability of a loss and a disproportionately smaller but safer profit?
Presented with such a choice, most investors would opt for the investment with the lower risk of loss. Yet mathematically, the expectation value of the first is higher than the expectation value of the second. The first is the rational choice, but it doesn’t look or feel that way. It seems emotions nearly always override rational reasoning. Why is this and is there anything that can be done to counter their influence on investment decisions?
“Every human being is driven by emotions – more than we would like to admit. Emotions are the drivers of our behaviour, and these behavioural patterns shape our way of investing, for better or worse,” says Christian Gattiker, Head Research at Julius Baer. In fact, emotions are so powerful that even when we are forewarned, we still fall prey to their influence. “People often have to find out the hard way that intuition and emotions are a trap.”
One of the most common traps is the tendency to sell shares that are gaining in value too early, while holding on to shares that are losing too long. “This is very common behaviour and one of the most typical pitfalls,” says Gattiker. “On the one hand, people see a gain and want to cash in now for fear it will reverse. On the other hand, they fall in love with a stock and don’t want to believe that it has gone out of fashion. No one is immune to these behavioural traits; they affect not just private investors but professional fund managers, too.”
The difficulty is that people are often not even aware of the irrational forces affecting their decisions. The behavioural patterns are implicit and therefore often overlooked or unknown. This may explain why, although the majority cannot help but be influenced by their emotions when making investment decisions, most, if asked, would say that they are not. Denial of the problem is the biggest hurdle to overcome. “Ask 100 people how they think they drive; the vast majority will say they are an above-average driver. But that cannot possibly be true. If you swap ‘car driver’ for ‘investor’, you would have the same response pattern,” says Gattiker.
It is a cruel truth that most of us have too high an opinion of ourselves. The realisation that we are not immune to the mistakes other investors make can be humbling. “Realising that you have fallen into one of the typical behavioural traps is painful,” says Gattiker.
One lesson that can be learnt is the value of rules and the importance of applying them in a systematic way. Yet this, too, is only half the story. If rules alone were enough, machines would consistently make better investment decisions than human beings. However, that is not the case. “The trouble with machines is that, while they are good at rule-based investment, they have no judgement. This means that they tend to be pro-cyclical,” says Gattiker. “Even if they are programmed to be contrarian, they are still following the cycle.”
The key to breaking out of this pattern is to use both judgement and rules together in a complementary way, not just rely on one. It’s necessary to use judgement to understand the dynamics of market movements but also to make a cool, rule-based assessment of the numbers.
It’s also vital to constantly expose your views to challengers. Among fund managers, this is achieved through a system of checks and balances. In each decision, at least two people are involved with very different perspectives. While decisions are driven by investment processes, they are still exposed to other views. “Seasoned professionals do not all think alike. Your portfolio will fare far better if it is run by a group than if it is run by one individual,” says Gattiker.
The worst traps may seem obvious, but they are hard to avoid:
- Attaching more credibility to stories that support our views and dismissing those that do not.
- ‘Herding’, where investors run in the same direction in the belief that the person in front of the herd knows more than they do.
- Paralysis caused by fear of doing the wrong thing – this phenomenon tends to occur when there has been a market crisis and investors have been spooked.
- Holding on to losers for too long and selling winners too early: the former is caused by paralysis at seeing the accounting value of the asset going below the purchase price; the latter is caused by impatience and the desire to cash in on a profit quickly.