By Andrew Maxwell and Alan Weider
No matter how rational or detached we’d like to think we are, the reality is that emotions often get the better of us. And when it comes to how we invest our money we have to be particularly attuned to our feelings in order to sidestep emotional traps. We look at ingrained biases that affect us as investors and how we can look past our emotions.
When it comes to making complex investment decisions, many people follow a series of simple rules of thumb that in many cases are based on deeply ingrained biases that lead to irrational decisions. While these biases might be useful in helping individuals cope with day-to-day choices, they can be unhelpful for achieving success in long-term activities such as investing. By gaining insight into investor behaviour, investors can be coached to understand their own biases and make better investment decisions.
This is the first in a series of articles exploring a behavioural finance topic that discusses some of the most common investment decision-making mistakes and provides practical tips for avoiding them.
We start the series this month with a focus on two of the most common investor biases: so-called “loss aversion” and “narrow framing.”
Fear of losing is a much stronger driver of behaviour than the potential for gains.
Loss aversion is a central concept in behavioural finance. It is captured in the phrase “losses loom larger than gains” that was coined in the groundbreaking 1979 paper, Prospect Theory: An Analysis of Decision under Risk, by Nobel laureate Daniel Kahneman and the late Amos Tversky. Experiments by the authors revealed that the pain of losing is psychologically about twice as strong as the pleasure from gains.
It is this aversion to loss that can drive investors to make emotional, rather than rational, decisions.
The decision not to invest is an active decision made every day. The fears of having missed the boat with an investment opportunity or that markets are too stretched are common and understandable objections that investors make. When this happens, investors often decide to wait on the sidelines for the next opportunity rather than put their money to work in the market. So how can investors learn to look past their emotions?
Try the overnight test
Consider the following situation. As an investor, you are holding a stock that is nursing a heavy loss but you just can’t bring yourself to sell.
Try the overnight test. How would you react if the stock was sold overnight and you woke up to cash in your bank account? Would you buy the stock back again? This “overnight test” is effective in determining an investor’s true attachment to an investment.
This test can be applied just as equally to investors who are holding a large amount of cash and are considering investing. If you woke up one morning to find stocks instead of cash, how would you feel? Would you immediately sell the stocks to rebuild your cash position?
Focus on the fundamentals
Investment managers often speak of how they focus on the fundamentals and for good reason. Media speculation focuses on the noise, while fundamentals—quantitative and qualitative data about companies or markets—act as signposts for the direction of stocks and economies.
Buying a share of a business that has a proven track record of growing sales, earnings, and dividends and which is able to reinvest retained earnings, on the shareholder’s behalf, at its internal rate of return, which is typically far higher than the growth rate of the economy, tells you at least 95% of what you need to know. News noise and the prospect for short-term fluctuations, too often the tail that wags this dog, fade into irrelevance by comparison.
The fear of loss can push investors to sit in cash in the belief that because markets have risen, they are certain to fall. It is true that markets do not travel upwards in a straight line and can fall or pull back as well as rise. Knowing where the economy is heading next is an important factor that allows investment decisions to be made with confidence. Economic expansions tend to be good for corporate earnings and stock prices, while recessions are unequivocally bad. Valuable indicators of which phase the economy may be entering include consensus forecasts of economists, central bank forecasts, and reliable leading indicator series.
Focusing on short-term stock or market movements often create a distorted view of the true value of a company or equity index and deter investors from taking the risks they are capable of taking.
There is a famous story told of Massachusetts Institute of Technology (MIT)Professor Paul Samuelson, a Nobel laureate in Economic Sciences. He offered his colleague a choice on a coin toss. If the coin landed on heads, his colleague would receive $200, but if it landed on tails his colleague would have to pay $100.
His colleague rejected the proposition because the potential pain of losing $100 was not worth the potential pleasure of the $200 gain. Instead, the colleague came up with a counteroffer, saying that, rather than doing it only once, he would be willing to do it 100 times.
If he was not willing to try once, why would he be happy to try 100 times?
Here’s “narrow framing” in an investment context. Imagine you have $10,000 to invest that is not required for the next five years. You are offered two funds whose performance is shown in the charts below. The chart on the left shows the month-by-month performance of an investment fund over the past five years. Meanwhile, the chart on the right shows the monthly equivalent returns for a fund in rolling five-year periods, from worst to best (e.g., a rolling five-year return for January 2012 would include returns for the period February 1, 2007 through January 31, 2012).
Experiments show that, based on the data in the charts, investors are more likely to pick the fund represented in the chart on the right. The prospect of steady positive returns from this chart is more appealing than the idea of very volatile monthly returns represented in the chart on the left.
Source: RBC Wealth Management
It should not be a surprise, however, that the two charts are showing returns from the same fund. By taking a longer-term view of performance—widening the frame—and allowing the short-term ups and downs to average out, investors are more likely to accept a higher level of risk. Learning to ignore short-term, narrow moves and instead focusing on long-running trends can lead to a more successful investing experience.
So, going back to our MIT professors, why was Professor Samuelson’s colleague happy to flip the coin 100 times but not once? If everything depended on one coin flip then there would be a 50% chance he was going to lose $100. But over 100 flips there would likely be something in the neighbourhood of 50 heads and 50 tails and by agreeing to change the potential loss and gain to $1 and $2, respectively, then he would have to encounter 100 tails in a row to lose $100—a very, very unlikely outcome. Because of the $2 payout on heads versus just a $1 cost on tails, any result better than 33 heads out of 100 flips would earn him a profit. In other words, by “widening the frame” Professor Samuelson’s colleague improved his chances of earning a profit (or not losing) to 67% from 50%.
For more on this topic, we will publish additional Emotional Investing articles in the coming months in Global Insight.
Non-U.S. Analyst Disclosure: Alan Weider, an employee of RBC Wealth Management USA’s foreign affiliate Royal Bank of Canada Investment Management (U.K.) Limited; and Andrew Maxwell, an employee of RBC Wealth Management USA’s foreign affiliate Royal Bank of Canada Investment Management (C.I.) Limited; contributed to the preparation of this publication. These individuals are not registered with or qualified as research analysts with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since they are not associated persons of RBC Wealth Management, they may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.