MICHEL PIREU: On irrational behaviour and the large role it plays in investment decisions

There is a growing awareness of the human flaws that play havoc with our investment decisions and explain certain market anomalies. On the potentially damaging and ever-growing list of irrational or, at least slightly odd, behaviours in the sphere of investment are:

The Affect Heuristic: we use feelings more than logic to make decisions. “Many people seem to assume that the financial anxiety they feel is nothing more than a direct by-product of the Covid-19 crisis — a perfectly logical reaction to the disease,” says Robert Shiller. “But anxiety is not perfectly logical. In a joint paper with William Goetzmann and Dasol Kim we found that nearby earthquakes affect people’s judgment of the probability of a 1929- or 1987-size stock-market crash.

“If there was a substantial earthquake within 30 miles within the previous 30 days, respondents’ assessment of the probability of a crash was significantly higher. That is the affect heuristic at work ... It might make more sense to expect a stock-market drop from a disease epidemic than from a recent earthquake,” Shiller goes on to say, “but maybe not a crash of the magnitude seen recently.”

If it were widely believed that a treatment could limit the intensity of the Covid-19 pandemic to a matter of months, or even that it would last a year or two, that would suggest the stock market risk is not too great for a long-term investor. One could buy, hold, and wait it out. But financial anxiety has a life of its own, fuelled in part by people noticing others’ lack of confidence.

Dread Risk: the irrational fear of extreme events. To invest on the basis that something can always go wrong makes for intelligent investing. But most investors seem to operate in a risk on/off binary world that they judge from the performance of markets and the signals given off by price movements. 

To be fair, much of the time prices do provide useful signals, but there is something about the fear of extreme events that causes the risk switch to remain “on”.  Uncertainty is endemic in markets, but when this is reinforced by the apparent possibility of a financial Armageddon, dread takes over. When that happens, we stop thinking and start reacting. 

Regret: to feel sorrow and grief after an error in judgment. “Being wrong — not taking the loss — that is what does the damage to the pocket book and to the soul,” said Jesse Livermore. “Your head matters in this game,” says former hedge-fund manager and long-time Wall Street commentator Jim Cramer. “You need to have it on right every day if you are going to see opportunities and act on them.”

Yet so many of us have heads clouded with thoughts that genuinely throw us off target and make us do the wrong thing. The most damaging recurring thought is, “If only ...” As in, “I could have acted sooner …” Or “I should have pulled the trigger on …” Or “I would have made a fortune if only I’d … ” The solution? Reframe losses and missed opportunities as gains in lessons learned.

Framing effect: the idea that our choices are influenced by the way they are framed. The way we approach things plays a crucial role in how we assess probabilities. Even the same problem framed in a slightly different, but objectively equal, way can cause us to make radically different choices. The thing about framing is that it isn’t a psychological bias — it’s simply the way we make sense of the world. The trouble is that the way we look at things colours our perception.

Recency Bias: the predisposition to give too much weight to recent experiences and extrapolate recent trends even when they’re at odds with long-run averages and statistical odds. With the Great Recession just behind us, we are certainly well aware of the possibility of major drops in asset prices. But then we saw markets recover relatively quickly, followed by one of the longest bull markets in history.

Bringing many investors to believe in a V-shaped recovery to the current crisis and the fear of missing out. Which appears to have delinked markets from the economy. But, months into the pandemic, we are no more certain as to how it will play out or for how long. Predicting the stock market at any time is hard. Perhaps seldom more so than now. So better not to.

Loss Aversion: we treat losses and gains differently. We value losses more than equivalent gains — a dollar lost matters more to us than a dollar gained — which results in flawed investment decision-making. We seek risk when it comes to reducing our losses and run from it when it comes to protecting our profits. We become irrationally risk averse and overly fearful; unwilling to do trades that are in our best interests.

We also attach more value to something once we have made an investment in it. The overarching problem when it comes to investing, however, may have been captured best by novelist Veronica Roth when she said, “But I think that no matter how smart, people usually see what they’re already looking for, that’s all.”