Disciplined approach to investing avoids behavioural bias errors

The main influencer was Brexit, where Britain’s main stock exchange, the FTSE 100, lost 3,15% by close of the following session and a further 2,55% the following day, only to recover a few days later.

Locally, we are experiencing the effects of the worst drought in more than a century and this has had a negative impact in terms of growth and inflation. South Africa’s inflation has been above the upper target of 6% since the end of 2015 and our GDP came in at a negative 1,2% in the first quarter of 2016.

While we were given a reprieve by the ratings agencies in June, the risks of a downgrade still remain, especially with the instabilities in governing institutions and the disputes between the finance minister and the Hawks.

The past two quarters could be seen as an indicator of what the year ahead will be like - volatile. Investing according to an appropriate risk profile and staying invested for the entire investment time horizon becomes really important, now more than ever.

In such volatile times, managing investors’ common reactions and decisions, which are often based on biases, is important. It is impossible not to be biased in decision-making, but in order to mitigate potentially incorrect decisions, it is important to identify investors’ biases and create rules to avoid them.

These behavioural biases may result in irrational financial decisions caused by faulty cognitive reasoning or influenced by feelings. There are two types of behavioural biases; cognitive errors and emotional biases.

Cognitive errors

Cognitive errors are basic statistical, information-processing or memory errors that result in the decision deviating from being a rational one. These are mental conflicts arising from new information that contradicts existing beliefs. Because these errors stem from faulty reasoning, better information, education and advice can often correct them.

Framing bias: This is when an investor answers a question differently based on the way in which it is asked. As a result, risk tolerance may be misidentified which could result in suboptimal portfolios. An investor may be risk-averse when presented with a gain-frame of reference or risk-seeking when presented with a loss frame of reference, as they consider themselves to have nothing to lose.

To detect the framing bias, one should ask if the decision is based on a net gain or loss reference. However, intermediaries should refrain from using loss or gain references, but rather focus on future prospects of the investment.

Conservatism: This is when an investor maintains their past views or forecasts despite new information. Individuals with conservatism bias overweight their initial belief about probabilities and under-react to new information; they do not modify their beliefs and actions with new information. This can result in a delayed reaction to the information.

Conservatism can be corrected or reduced by proper analysis and weighing of new information. Investors should ask questions such as: “How does this information change my goals/forecasts and what impact does it have on my investment goals.”

Confirmation bias: This is when investors look for and notice that which confirms their beliefs and ignore or underweight that which contradicts their beliefs. This can also be viewed as selection bias. In this instance, investors may only consider positive information and ignore negative information. This can lead to under-diversification (highly concentrated portfolios), which could result in higher risk. Actively seeking information that challenges existing belief systems may reduce or correct for conservatism.

Representation bias: This is when an investor classifies new information based on past experiences and classifications. Under this bias, a view is likely to be adopted with new information, based on a small sample. For example, investors may hire and fire managers based on short-term performance as they only consider short-term performance to be normal and discount past, long-term performance. To overcome this bias, it is recommended that historical performance (for example, 10 years) of all the asset classes is presented to investors so that their decisions are not solely based on recent performance.

Availability bias: This is when investors choose easily available outcomes and unconsciously assume that a readily available thought, idea or image represents an unbiased estimate of statistical probabilities. This can result in decisions being influenced by media, failure to diversify, and failure to reach an appropriate asset allocation. It can also result in a limited opportunity set.

An appropriate investment strategy, a disciplined research and analysis process with a long term focus will help eliminate this short-term over-emphasis.

Mental accounting bias: According to this bias, money earned from different sources is treated differently and is therefore also invested differently. Mental accounting may result in investors placing investments into distinct buckets without accounting for correlations between asset classes across these buckets.

This can be seen where investors have different savings vehicles; for example, retirement savings, emergency savings or education savings. When these are placed in separate vehicles, their effect on each other is ignored which may result in over-exposure to a particular asset class or stock.

To combat this bias, investors should consider an investment summary which shows all the different investments and asset allocations on a look-through basis. This will help avoid asset class concentration.

Illusion of control: This is when investors believe they can influence or control outcomes when in actual fact, they cannot. This can result in excessive trading, over-diversification and highly concentrated positions in companies that investors feel they have control over. This hindsight bias feeds the illusion of control negatively, where investors may see past events as being predictable and reasonable to expect.

Investors need to recognise that successful investing is a probabilistic activity, which may not be fully predictable. It is important to seek different views before investing and also keep records of investment decisions including the reasons behind them. This will help the investor see whether they can predict the market or not.

Emotional biases

Emotional biases, on the other hand, are spontaneous, as a result of attitudes and feelings - which result in decisions being irrational. They stem from impulse or intuition, are often personal and sometimes based on unreasonable judgement.

They are therefore not easy to correct. It is important to recognise an emotional bias and adapt it. This means that the bias is accepted and decisions made recognise and adjust for it rather than eliminate it. Let us now look at both cognitive errors and emotional biases in a bit more detail, in order to understand the types of biases investors are often exposed to.

Loss-aversion bias: This is when investors prefer avoiding losses as opposed to achieving gains. According to studies, psychologically, losses are significantly more powerful than gains. This means that investors feel the pain of loss more than the joy of gains. They’re therefore more concerned about losing money when markets fall than growing it when markets climb. While it is not possible to make the experience of losses any less painful, a disciplined approach to investing based on fundamental analysis should help identify probabilities of future losses and gains.

Self-control bias: This is when there is a conflict between short-term satisfaction and the achievement of long-term goals. Under this bias, people fail to act in pursuit of their long-term overarching goals because of a lack of self-discipline.

Here, proper investment planning and personal budgeting is key to long-term investment goals. Recording, reviewing and seeing these plans through is important in achieving long-term investment goals.

Recency bias: Recency bias is evident when investors buy into a stock, asset class, region or fund because of its current or recent rally. The belief that the investment will continue to rally supports this bias. This can also be linked to the availability bias which is a cognitive bias.

Longer-term data should be considered to put the present environment into context. A consistent and research-driven investment process is key. Exposure to financial media should also be carefully managed as it can exaggerate the impact of recent information.