Investing Irrationally- Behavioural Economics

We recently wrote about risk profiling and how we align our clients’ goals to the dynamics of the markets and their assessed risk profile. You can read more about it here.

Everything we discussed in that article concerned logical, quantifiable, scientific approaches to measurement, application and action. In real life though a large part of economics and investment is driven by our emotions. This is the relatively new field of Behavioural Economics.

Put simply, this is a field that draws from psychology and economics and seeks to understand our purchasing and investment decisions.

Following economic principles, we are expected to act in a rational manner, weighing up options, pros and cons and risks to make the best decision. However, the research has shown our investment decisions are also influenced by emotion, by our (several) internal biases, and by incomplete information that can result in us making decisions that are sometimes not in our best interest.

A practical example of this is comparing purchasing and investment patterns. When we shop, we are quite comfortable with the idea of buying items when they are on sale rather than when they are at their maximum price. There are exceptions to this and there is an interesting and separate field of study around some luxury items like motor vehicles, perfumes etc, where the more the price increases the more desirable they become and the more people and willing to purchase them. But let’s ignore that specific sub-set for now. In general, we are happy to make purchases in sales. Or in investment parlance, buy when there is a drop in the price. When it comes to investing though, behavioural economics suggests we are much more reluctant to do this. The more normal pattern in investing is to purchase when the prices have risen, as this is interpreted as buying something that is performing well. Further, when prices do drop, we are less likely to buy, even though that asset may be considered as being ‘on sale’ and are more likely to sell. This links directly to one’s risk profile and it is a very important part of our value add to keep a client’s goals, risk profiles and investment portfolios aligned, across market cycles. So, even though we know intuitively that for investment success we should buy low and sell high, in practice this can be a difficult thing to do.

A factor in this decision making is access to incomplete information. As we have said in other articles, markets tend to be cyclical with a long-term upward trend. However, when for example, a stock is rising in price, it is often perceived that it will rise for ever and so investors will try and get on the bandwagon, often too late. When markets start falling, we often sell a stock, or at least hold off and don’t buy. It can be said that the best course of action is to buy low and sell high, but our emotions that form our behavioural economics driven actions force the opposite actions so that we buy high and sell low. Not a good recipe for success.

The illustration below shows the momentum driven impact of investing based on behavioural triggers that leads to buy high, sell low.

Don’t do this:

Behavioural economics is complex and there are a number of impacting factors. Some of these include a lack of complete information, a misunderstanding of the cyclical nature of an investment, a mis-match with one’s volatility threshold, movement in the short-term stock price, and the dominance of loss aversion over growth potential. The last factor is quite well studied. In essence, humans in certain situations will prefer to minimise a loss than achieve a gain, and in doing so sometimes compare and confuse short term potential losses with long term gains. An important aspect to keep top of mind is that a loss on paper is an unrealised loss. That means you haven’t actually incurred that loss until you sell the investment. To illustrate this, think real estate. If you buy a property you tend to attribute its value as the amount you paid, or a value relative to the prices of similar properties recently sold. You tend not to get your property valued regularly. If you did however, and it was valued 20% lower than you paid for it, you haven’t actually lost that 20% of capital, unless you sell it. The price valuation can recover and grow over time. It is the same with other investment assets. The difference is their price is reported daily, weekly or monthly. Interestingly, frequent exposure to prices can make us more nervous and loss averting investors, which can impede our longer-term goals. In fact this is something I wrote about nearly 25 years ago where I stated there is an inverse relationship between one’s ability to achieve a long-term investment goal and the frequency of exposure to the unit price. Its still relevant today.

We believe in sticking to investment principles and that you cannot consistently time the market optimally. Research has shown that just by missing out on the best 5 days in the market between 1980 and 2019 could mean a 35% lower result¹! A commonly made statement is that it is time in the market not timing of the market that creates wealth.

We agree with this principle but acknowledge that it can also be more complex than that.  Accordingly, our investment philosophy is dynamic investment management incorporating client goals, risk profiles, duration, any other relevant external factors and then adjusting appropriately across cycles. But we do not recommend jumping in and out trying to time markets. We collaborate with particular specialist managers that alter the asset mix in an investment portfolio to generate steadier lower volatility returns, in line with targets and minimising the risks that behavioural economics describe.

In summary, behavioural economics makes for interesting and sometimes surprising reading and can help you understand more about the psychology behind purchasing and investment decisions. A large part of our value add to our international clients is to keep you on track, aligning your investments to your goals and ensuring your investments can work for you across all market cycles.

¹ Reference: https://www.thesimpledollar.com/investing/stocks/tempted-to-sell-missing-just-a-handful-of-the-best-stock-market-days-can-tank-your-returns/