Welcome to Part 5 of our Behavioural Finance series. If you’ve missed the earlier parts of the series, you’ll find our Introduction to Behavioural Finance here, Part 2: Prospect theory and loss aversion here, Part 3: Availability and Representativeness here and Part 4: The Law of Small Numbers here.
The way we receive and process information has a big effect on how we make decisions about investing. This week we look at some examples of these effects, and consider how we can be alert to common biases when exercising our own investment choices.
One of the most startling findings of the study of behavioural economics is the research into anchoring. Anchoring is the tendency to attach our thinking to a reference point, even if the information has no relevance to the decision we’re making. For example, a group of students in the US were told to write down the last two digits of their social security number, and then asked to give a value to a number of randomly chosen retail products. The results clearly showed that those with higher social security numbers gave the products higher values than those with lower social security numbers. The social security number, although completely irrelevant, provided the ‘anchor’ that influenced the answer.
We see this employed quite regularly as a sales technique. A second-hand car salesman might start the conversation with a high price from which he expects to be haggled down. Given the power of the anchor, he’ll probably end up with a final price that will be higher than had he begun with an amount closer to the car’s actual value.
The property market provides another good example. If you have your house valued by a range of estate agents, they might produce a variety of different asking prices. It is human nature to anchor on the highest price. When people come to sell and find the house doesn’t fetch the top valuation price, this can stop them from moving on – even if it’s still a good price, provides a decent profit, and the move is the right decision according to their life plans.
Sometimes, people can cling to anchors as a reason for not taking action and for sticking with the status quo.
Conservatism bias is related to anchoring and happens when we see an investor clinging on to an initial opinion about an investment without properly incorporating new information. They consider their original view to be more meaningful and important than any information they learn afterwards. Typically, they take action on the basis of the old information but are less willing to act on new information that conflicts with it.
Professor Kahr explains some of the factors that can inform our behaviour:
“Many people have a very primitive, even irrational, relationship with money. For instance, when selling one’s house, the haggling might represent a deep-seated greed, but it might also serve as an indication of our fear of loss. Some owners might set an unreasonable price because, at one level, they do not actually wish to sell the house, since they have lived there with their family for a long time, and might fear a kind of psychological homelessness.”
Professor Kahr further underscored: “One’s private relationship with money may have nothing to do with one’s objective net worth. Many of us feel a sense of internal impoverishment of character, often due to early experiences of emotional deprivation. Consequently, many “rich” people with assets might actually consider themselves as never having enough money, partly due to greed but, also, partly due to psychological loss, this sense of internal impoverishment.”
Apparently, on the eve of the 1929 stock market crash, business magnate and philanthropist, John D Rockefeller had said that when the bellhop in your hotel starts talking about share tips, it’s time to get out of the market. Whether this tale is true or not, it certainly helps to highlight the danger of herding when choosing your investments.
The most obvious example to cite from our era is the dotcom bubble of 1999-2000. Fund managers were investing huge sums of money in new internet-related ventures. It can be particularly tempting to follow the crowd when you don’t have a full understanding of the situation – the reassurance of seeing so many others doing the same thing can exert a powerful influence (“all those people can’t be wrong, they must know something I don’t!”).
Herd behaviour, following the crowd, conforming: whatever you call it, it’s a common human instinct and one that can impact investors and advisers in equal measure. Professor Kahr notes:
“Following the herd is a very basic and primitive instinct in human nature and relates to our fear of loneliness. It’s very difficult to go against the grain in all walks of life but particularly in investing when missing out on a financial reward can put an investor in a very lonely place.”
The Effect on Investing
Of all the biases we look at in this series, anchoring is probably the one we come across most regularly as advisers. Often clients can have an idea of the percentage return they are looking for from their investments – say, for example, 7% – and might be looking to see this level of growth consistently year on year. In the 100 years between 1917 and 2016, 7% has been the average annual return for the FTSE All-Share Index but the market will very rarely return the average in a year. In the 30 years between 1987 and 2016 the same index returned above 7% on 18 occasions (the highest being 30%) and below on 12 (the lowest being -32.8%).1 Given the portfolio is structured for the long term, we should build this level of fluctuation into our expectations over the investment cycle. As advisers, we need to work closely with investors to ensure that short-term anchoring doesn’t become the nemesis of a long-term disciplined investment approach.
Time was when there only used to be a handful of funds to invest in. In some ways, herding has reduced, as there’s now a much wider mandate of investments to choose from. However, the increased influence of the media – particularly social media – and the ability of investors to more easily find a herd to follow could be said to have increased it.
The demand for buy-to-let properties shows us this. The government has recently introduced regulation to make buy-to-let a less attractive option, but it nevertheless remains popular. Many investors are keen to invest in property in the belief that it will always increase in value but, as we advise, this is not always the case. Like any investment, buy-to-let might make up a part of the portfolio but investing all your money in it because everyone else is doing it would not be something we would recommend to our clients.
This is where the role of the adviser is vital. It’s our job to offer guidance based not on what the most current craze is, but on professional insight with an eye on the long-term security and prosperity of your investments.
If you would like some help in planning your ideal financial lifestyle, please feel free to get in touch.
Questions to Ask Yourself
How strongly do you agree or disagree with the following statements?
- I compare my investment performance to how other investors have been doing
- I would not feel that my investments were performing well unless they were doing better than the stock market
- I would be reluctant to sell an investment that had decreased in value since I bought it
- If a lot of people I knew had made a similar investment, I would feel comfortable not seeking independent advice about it
Next post: Overconfidence and Under-Confidence.
1 Source: http://stockmarketalmanac.co.uk/2016/12/100-years-of-the-ftse-all-share-index-since-1917/
This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.