Understanding the impact of bias on investing

Since the early days of behavioural economics (born in the late 1960’s), much has been made of the evolution of our understanding of investor behaviour.

While once it was believed that investors always make rational decisions based on all the information available, leading thinkers like Daniel Kahneman in his work with Amos Twersky identified many heuristics (mental shortcuts) that people use on a daily basis, which can drastically effect decision making. These decision-making outcomes are often predictable, but it’s only with the benefit of hindsight that the perpetrator of those decisions recognises their error.

We’ve previously discussed examples of mental heuristics and their impact on decision making. Revisiting and expanding our understanding of this key area, is (and must continue to be) an ongoing endeavour.

Take a moment to consider the following questions. Try to answer these questions out loud as quickly as you can - answers are available at the bottom of the page:

1. There are water lilies on a lake. Each day, the amount of water lilies doubles. After 20 days there are so many water lilies that the entire lake is covered. After how many days was half of the lake covered?
2. A racket and a ball cost $1.10 in total. The racket costs $1 more than the ball. How much does the ball cost?
3. There are two hospitals in a city, a small and a big one. In which of them is the likelihood higher of substantially more boys than girls being born in one day? (Provided that girls and boys are on average born equally frequently)

• a) The big hospital
• b) The small hospital
• c) The chances are equal for both

4). Five machines produce five plates in five hours. How much time do three machines need for three plates?

For those who didn’t get all the above questions correct, don’t be too hard on yourself. The questions are specifically designed to illustrate how our minds will fight our better senses and insist on relying on our natural intuition rather than engage in the ‘deep thinking’ part of our brains.

Some of the pitfalls discussed by behavioural economics that are common include:

Herding: Following the crowd. It describes the tendency to feel comforted by the knowledge that other investors share your enthusiasm in a particular sector or company. It explains why social media and chat groups can have such a profound impact on investment decision making.

Anchoring: Describes the behaviour of an investor that is slow to react to new information. The investor in ‘anchored’ to their previous ideas and unwilling to shift their view despite new data suggesting a change in circumstances. Anchoring is sometimes manifest when an investor who has fallen in love with a stock is unable to sell when the share price is below their purchase (or initial valuation) price. The same can occur for buyers of stock, who psychologically struggle with making a purchase decision when a share price has moved slightly above the point at which the buyer first thought to buy.

Recency Bias: A situation where investors assume that what happened today and yesterday will continue to happen into the future. This challenge sees otherwise sensible individuals disregard the evidence of decades (or generations) and simply assume that what is currently occurring will continue to occur into the future. This psychological phenomena is often the cause of the greatest periods of volatility in markets. When markets and the economy are strong, investors are willing to price companies to unreasonable heights (think the ‘buy-now-pay-later sector which was trading on multiples of prospective revenue rather than a profit multiple), or crushing lows (when markets are weak and investors can’t see past the near term pessimism, companies trade at unreasonably low multiples).

Loss Aversion: A concept that measures the difference between the pleasure of success against the pain of failure. Studies have shown that it is somewhat common for investors to weigh the pain of a $1 loss as 2.5 times more ‘heavy’ than the satisfaction of a $1 gain.

All of these factors are understandable, and there are certainly tools available to us all to manage and limit their impact on our decision making. However as always, the first step in correcting a problem is recognising that one exists – and that’s not easy.

It’s beyond the scope of this article to resolve personal investment and psychological challenges, but two tools that we often use within the office include:

1. Think about the problem overnight. It’s extremely rare that a decision needs to be made in haste, and if you think that a matter in front of you is one of those rare occasions, take the night to consider it to be sure.
2. Find an investment buddy. Have someone that you can discuss your ideas with. A compatriot who is both interested in investing, and willing to challenge your ideas.

Those two concepts will save most investors from most of their terrible decisions.

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Look out for part two in the coming days where we will consider investor behaviour and the impact of uncertainty.

Answers to the riddles:

1) 19 days. 2) $1.05 for the bat plus 5c for the ball. 3) b: The smaller hospital is more likely to experience outlier events due to its small sample size. 4) 5 hours.

more information on the topic above can be found in the following readings:

“The Psychology of Preferences”, Daniel Kahneman and Amos Tversky. “How Do Investors React Under Uncertainty”, Ron Bird & Danny Yeung (University of Technology, Sydney). “Rational Investing in an Age of Uncertainty”, Harlan Levinson (Morgan Stanley). “Judgment under Uncertainty: Heuristics and Biases”, Amos Tversky & Daniel Kahneman (Journal of Science). “The Impact of Uncertainty on Investor Behaviour”, Larry Swedroe.