The Dot Com bubble that grew and popped just 15 years ago is probably the best example of highly irrational behaviour on the part of investors.
The rapid rise and subsequent plunge in technology stocks through this period was propelled by an initial flood of money into internet start-up firms, was maintained by the faddish entry by more and more investors and then killed-off by the realisation by the market that many of the firms were unlikely to turn a profit and therefore not valued correctly and hundreds of times their annual earnings.
According to FE Analytics, the average portfolio in the IA Technology & Telecoms sector soared nearly 400 per cent in the 18 months from October 1998 to March 2000. It then fell 80 per cent until June 2002.
Performance of sector during Dot Com bubble
Source: FE Analytics
Head of multi-asset at L&G Investment Management’s John Roe says the impact of such behavioural biases by investors can be very strong and in this article he explains how investors can come to behave in such a manner though 11 common biases.
1. “Viewing investing as a series of isolated gambles may make you overly risk averse.”
First up is he says a tendency to see each portfolio component as detached investments rather than a series of bets which may offer favourable odds over the longer term, leads to too defensive positioning.
“Viewed collectively as a set of decisions with a very clear potential upside, more people would be willing to take more risk.”
“Unfortunately, we are systematically tempted to take too little risk and, with access to more information, the internet age makes this problem worse.”
This can sum up to investors being too short-term in decisions rather than looking at the long term potential.
“The more you see short-term, isolated events it will lead to too little risk being taken over a period of time.”
2. “Gains are worth less than losses at least in investors’ minds.”
“Would you rather win £10m and then lose £9m or win £1m without any of the stress of those nasty losses?” Roe said.
Ultimately the two examples have the same outcome but he thinks it is clear what most people would choose.
Roe says too often investors preoccupying themselves about losing some of their recent strong returns rather than being happy they are better off in absolute levels.
“It is bit like the CNN owner Ted Turner actually in tears on television after the tech bubble burst because he was no longer a multi-billionaire though he was, nevertheless, still a billionaire!”
3. “The frame you place on something is an important influence on a decision – framing can fool us all.”
Next, Roe says it is possible to influence someone’s decision by the way you ‘group options’.
“Framing fools us all, and the way options are presented can certainly bias towards one over another.”
“It is worth bearing in mind, when someone is extolling a number of ‘excellent investment opportunities’ that they may be pushing you towards one on purpose or even doing so simply as a result of their own biases.”
4. “Once anchored to an initial value, people never adjust enough when making decisions.”
Put simply, Roe (pictured)says it is important to make your decisions based on a wide as possible pool of information.
“Investors given more information may adjust it up but it is not likely to be far enough. So if you read the FT in the morning, and it is full of positive stories, you may be excessively positive all day.”
He thinks the ‘anchor’ of the information such as reading a positive story about a particular market, UK mid cap equities for example, will always guide your expectations and so the wider the mix of opinions the more open your reasoning will be.
5. “Issues that are being widely discussed and information that is more easily available will have more influence on decisions”
This applies to news stories. If the prevailing atmosphere in the media is fearful, then that will influence decisions but they may not be the correct ones.
“A useful exercise here involves considering the ratio of words in English which start with an ‘R’, say Rabbit, to those words with ‘R’ as the third letter, so, say caR. Most people will overstate the Ratio as thRee to one. It is actually one to one.”
“That is because we Remember moRe woRds that start with R than Recognise those woRds which have it as a third letter.”
6. “Don’t neglect the ‘base rate’ - people tend to think they can beat the odds.”
This maximum could also be worded as ‘don’t think you are better than average’ at picking funds or markets and Roe says beware of overconfidence in yourself and others.
“Ask a room of investment professionals about their skills in picking a fund or a stock and you may find that 75 per cent will say they are better than average. But only 50 per cent can be better in terms of a large audience at least.”
7. “The endowment effect or what you own you (over) value.”
Next he says people too often get stuck with their favourite funds or stocks, which is a strong reason few investors would ever decide to sell all their holdings and start with a blank piece of paper and start again.
“For example long term investors in oil production companies may have had a difficult time adjusting to recent share prices, though they also need to consider whether selling is crystallising their losses.”
8. “Status quo bias or anything for a quiet life.”
Investors all too often are fearful of regretting decisions and so do nothing so not to overload on the regret of selling something that has gone up for fear of losing out on even more upside.
Roe said: “It is within the power of all us to do nothing. We prefer not to change. This basically works on the premise that not making an alternative decision is less painful than choosing a new option.”
“You might say this evens out, but because you overweight losses to gains in your head, you are less likely to sell – hence the status quo bias.”
An example of this could the once stock market darling ASOS. Many long term holders of in their small cap funds such Harry Nimmo, who heads the Standard Life Investments UK Smaller Companies fund and trust, kept hold of it rather than sell after thousands of percent of gains only to see it fall substantially last year.
Performance of stock over 10 yrs
Source: FE Analytics
9. “Confirmation bias.”
It is common, Roe says, once investors make a decision they don’t like changing it, which can lead to both missed gains and crystallised losses.
“They believe they are right and have overconfidence about it. Therefore new and useful information, which doesn’t agree with someone’s current thesis, will often be discounted while less useful information may be used to confirm existing views. Investors do this all the time,” he said.
Then, once they have received new information that doesn’t confirm their original investment case, they may fail to process it properly.
10. “Recency bias - attaching too much importance to what has just happened”
According to Roe an observed correlation between the ownership of equities and their recent performance is evidence that investors tend to chase returns or shy away from fallen markets.
“You generally find that after markets have fallen, people get negative and that after markets have risen people get more positive.”
“At worst it means people buying at or near the top of the market and selling at or near the bottom. Not a formula for success.”
11. “Egocentric bias or believing you are immune to many of these biases.”
Last up and perhaps most important of all is the belief that we are each more influential than we are influenced.
“You will tend to remember your investment wins over your investment losses. You will tend to over-estimate the positive impact in any joint decision making.”
“Other people think this way too, but understanding this can help make you a better investor, though I would suggest you don’t get too egotistical about it.”