Tag Archives: Finance

Decoding cognitive biases: what every investor needs to be aware of

By Robert Wright /August 23,2024/

Common human biases that investors should understand when it comes to investing is extremely important. These biases are ingrained in human nature, leading to tendencies to oversimplify, rely on quick thinking or exhibit excessive confidence in judgments, which may lead to investment mistakes. By gaining insight into these biases, investors may be able to make better decisions to help reduce risk and improve their investment outcomes in the long-term.

Numerous cognitive biases can affect how decisions are made. The key to mitigating these biases lies in recognising their presence, identifying when they might arise and then either making appropriate adjustments or obtaining help to moderate their impact.

Seven cognitive biases that might arise at various stages of an investor’s investing journey.

Herding: The tendency to follow and mimic the actions of a larger group.
Confirmation bias: The preference for information that confirms one’s existing beliefs or hypotheses.
Overconfidence effect: Excessive confidence in one’s own investment decisions and abilities.
Loss aversion: When the fear of loss is felt more intensely than the elation of gains.
Endowment effect: Overvaluing assets because they are owned.
Neglect of probability: Disregarding the actual likelihood of events and often overemphasising rare occurrences at the expense of more probable outcomes.
Anchoring bias: The tendency to rely too heavily on a past reference or a single piece of information when making decisions.

Herding

The herd mentality occurs when people find reassurance and comfort in a concept that is widely adopted or believed by many others. In recent times, we have seen the herd mentality with the events that surrounded the GameStop stock event. Where many people saw the rise in stock prices and without proper investment research followed the trend of many others and invested.

This impacted a lot of investors who bought the stock due to the fear of missing out and the hype it created. We believe, to be a successful investor, you must be able to analyse and think independently. Speculative bubbles are typically the result of herd mentality. Herd mentality in investing can overshadow rational decision making and could increase the risk of financial losses.

Investors need to recognise the feeling of pressure to conform to popular opinion or follow the crowd and instead consider conducting research and analysis before making decisions, as well as seeking alternative views to challenge the consensus.

Confirmation bias

Confirmation bias is the tendency to favour information that corroborates pre-existing beliefs or theories. In our view, confirmation bias can lead to significant errors in investing. Investors may develop an inflated sense of certainty when they encounter consistent evidence supporting their choices. This overconfidence can create an illusion of infallibility, with an expectation that nothing can go wrong.

Overconfidence bias

Overconfidence bias in investing is where investors overestimate their knowledge, intuition and predictive capabilities, often leading to poor financial decisions. This bias can present itself through various ways such as excessive trading, under-diversification and the general disregard for potential risks.

Investors with overconfidence bias tend to believe they can time the market or have the ability to pick the winning stocks better than most, which in turn may also result in overtrading and increased transaction costs. Overconfidence can also lead to a lack of proper risk assessment and analysis, as investors might underestimate the likelihood of negative events or industry dynamics affecting their investments.

An example of overconfidence bias occurred during the dot-com bubble of the late 1990s and early 2000s. Many investors were overly optimistic about the growth potential of internet related companies. This led to inflated stock prices as more and more people invested in these companies without proper evaluation of their actual worth.

Loss aversion

Loss aversion is where a real or potential loss is perceived as much more severe than an equivalent gain. The pain of losing is often far greater than the joy in gaining the same amount.

This overwhelming fear of loss can cause investors to behave irrationally and make bad decisions, such as holding onto a stock for too long or too little time. For example, an investor whose stock begins to tumble, despite clear signs that recovery is unlikely, may be unable to bring themselves to sell due to the fear of loss in the portfolio. On the flip side, when a stock in the portfolio surges, they may quickly cash out, not wanting to see the possibility of those profits disappearing.

When an investor clings onto failing stocks, departs with successful stocks too quicky and fear governs their investment decision, it’s known as the disposition effect. It’s a direct consequence of loss aversion, leading investors to make overly cautious choices that ultimately undermine their financial goals.

So, understanding this bias may help investors make rational decisions to grow their portfolios while managing risk effectively.

Endowment effect

Closely related to the concept of loss aversion is the endowment effect. This effect arises when individuals place a greater value to items because they own them, as opposed to identical items that they do not own. It’s a cognitive bias where ownership elevates the perceived value of an item beyond its objective market value.

For example, an investor may develop a strong attachment to a particular stock. It could be the very first stock they ever invested in, or they may favour the company for a particular personal reason such as aligning with their values. If this stock begins to fall and financial experts are advising to sell, because of the value bias this investor has they may be unwilling to sell. The investor perceives the stock’s value as greater than what the market dictates, purely because of ownership. It is a delicate balance that is needed to be able to determine between attachment and sound financial decision making and can be challenging for some investors.

To help mitigate the endowment effect, investors should regularly review their portfolios and consider the help of a financial adviser. Establish clear, predefined criteria for selling assets, aligned with financial goals. Develop a detailed investment plan with specific financial goals, a well defined investment strategy is crucial to prevent emotional decision making. Understanding and focusing on long-term investment goals can also help in maintaining objectivity.

Neglect of probability

Humans often overlook or misjudge probabilities when making decisions, including investment decisions. Instead of considering a range of possible outcomes, many people tend to simplify and focus on a single estimate. However, the reality is that any outcome an investor anticipates may just be their best guess or most likely scenario. Around this expected outcome, there’s a range of potential results, represented by a distribution curve.

This curve can vary widely depending on the specific characteristics of the business involved. For instance, companies which are well established and have strong competitive positions, tend to have a narrower range of potential outcomes compared to less mature or more volatile companies, which are more susceptible to economic cycles or competitive pressures.

Another error investors may make is to overestimate or misprice the risk of very low probability events. That does not mean that ‘black swan’ events cannot happen but that overcompensating for very low probability events can be costly for investors.

Anchoring bias

Anchoring bias is the inclination to excessively rely on a previous reference or a single piece of information when making decisions. Numerous academic studies have explored the impact of anchoring on decision making. Typically, these studies prompt individuals to fixate on a completely random number (such as their birth year or age) before asking them to assign a value to something. The findings consistently demonstrate that people’s responses are influenced by the random number they focused on prior to being asked the question.

Looking at a recent share price is a common way investors may anchor their decisions. Some people even use a method called technical analysis, which looks at past price movements to predict future ones. However, just because a stock’s price was high or low in the past doesn’t tell us if it’s a good deal now.

Source: Magellan

Three reasons to err on the side of optimism as an investor

By Robert Wright /December 01,2023/

Introduction

The “news” as presented to us has always had a negative bend, but one could be forgiven for thinking that it’s become even more negative with constant stories of disasters, conflict, wrongdoing, grievance and loss. Consistent with this it seems that the worry list for investors is more threatening and confusing. This was an issue prior to coronavirus – with trade wars, social polarisation, tensions with China, worries about job loss from automation and ever-present predictions of a new financial crisis. Since the pandemic higher public debt, inflation, geopolitical tensions and rising alarm about climate change have added to the worries. These risks can’t be ignored but it’s very easy to slip into a pessimistic perspective regarding the outlook. However, when it comes to investing the historical track record shows that succumbing too much to pessimism doesn’t pay.

Three reasons why worries might seem more worrying

Some might argue that since the GFC the world has become a more negative place and so gloominess or pessimism is justifiable. But given the events of the last century – ranging from far more deadly pandemics, the Great Depression, several major wars and revolutions, numerous recessions with high unemployment and financial panics – it’s doubtful that this is really the case viewed in the long term sweep of history.

There is no denying there are things to worry about at present – notably inflation, political polarisation, less rational policy making and geopolitical tensions – and that these may result in more constrained investment returns. But there is a psychological aspect to this combining with greater access to information and the rise of social media to magnify perceptions around worries. All of which may be adding to a sense of pessimism.

Firstly, our brains are wired in a way that makes us natural receptors of bad news. Humans tend to suffer from a behavioural trait known as “loss aversion” in that a loss in financial wealth is felt much more negatively than the positive impact of the same sized gain. This probably reflects the evolution of the human brain in the Pleistocene age when the key was to avoid being eaten by a sabre-toothed tiger or squashed by a woolly mammoth. This left the human brain hard wired to be on guard against threats and naturally risk averse. So, we are more predisposed to bad news stories as opposed to good. Consequently, bad news and doom and gloom find a more ready market than good news or balanced commentary as it appeals to our instinct to look for risks. Hence the old saying “bad news and pessimism sells”. This is particularly true as bad news shows up as more dramatic whereas good news tends to be incremental. Reports of a plane (or a share market) crash will be far more newsworthy (generating more clicks) than reports of less plane crashes this decade (or a gradual rise in the share market) ever will. As a result, prognosticators of gloom are more likely to be revered as deep thinkers than optimists. As English philosopher and economist John Stuart Mill noted “I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.”

Secondly, we are now exposed to more information on everything, including our investments. We can now check facts, analyse things, sound informed easier than ever. But for the most part we have no way of weighing such information and no time to do so. So, it’s often noise. As Frank Zappa noted “Information is not knowledge, knowledge is not wisdom”. This comes with a cost for investors. If we don’t have a process to filter it and focus on what matters, we can suffer from information overload. This can be bad for investors as when faced with more (and often bad) news, we can freeze up and make the wrong decisions with our investments. Our natural “loss aversion” can combine with what is called the “recency bias” – that sees people give more weight to recent events in assessing the future – to see investors project recent bad news into the future and so sell after a fall. As famed investor Peter Lynch observed “Stock market news has gone from hard to find (in the 1970s and early 1980s), then easy to find (in the late 1980s), then hard to get away from”.

Thirdly, there has been an explosion in media competing for attention. We are now bombarded with economic and financial news and opinions with 24/7 coverage by multiple web sites, subscription services, finance updates, dedicated TV and online channels, chat rooms and social media. This has been magnified as everything is now measured with clicks – stories (and reporters) that generate less clicks don’t get a good look in. To get our attention, news needs to be entertaining and, following from our aversion to loss, in competing for our attention, dramatic bad news trumps incremental good news and balanced commentary. So naturally it seems the bad news is “badder” and the worries more worrying than ever which adds to a sense of gloom. The political environment has added to this with politicians more polarised and more willing to scare voters.

Google the words “the coming financial crisis” and it’s teeming with references – 270 million search results at present – and as you might expect many of the titles are alarming:

“A recession worse than 2008? How to survive and thrive”.

“Could working from home cause the next financial crisis?”

“Economic crash is inevitable”.

“Three men predicted the last financial crisis – what they’re warning of now is terrifying”.

“How China’s debt problem could trigger a financial crisis”.

People have always been making gloomy predictions of “inevitable” and “imminent” economic and/or financial disaster but prior to the information explosion and social media it was much harder to be regularly exposed to such disaster stories. The danger is that the combination of the ramp up in information and opinion, combined with our natural inclination to zoom in on negative news, is making us worse investors: more distracted, pessimistic, jittery and focused on the short term.

Three reasons to be optimistic as an investor

There are three good reasons to err on the side of optimism as an investor.

Firstly, without a degree of optimism there is not much point in investing. As the famed value investor, Benjamin Graham pointed out: “To be an investor you must be a believer in a better tomorrow”. If you don’t believe the bank will look after your deposits, that most borrowers will pay back their debts, that most companies will see rising profits over time supporting a return to investors, that properties will earn rents, etc. then there is no point investing. To be a successful investor you need to have a reasonably favourable view about the future.

Secondly, the history of share markets (and other growth assets like property) in developed, well managed countries, with a firm commitment to the rule of law, has been one of the triumph of optimists. Sure, share markets go through bear markets and often lengthy periods of weakness – where pessimists get their time in the sun – but the long term trend has been up, underpinned by the desire of humans to find better ways of doing things resulting in a real growth in living standards. This is indicated in the next chart which tracks the value of $1 invested in Australian shares, bonds and cash since 1900 with dividends and interest reinvested along the way. Cash is safe and so fine if you are pessimistic but has low returns, and that $1 will have only grown to $250 today. Bonds are better, and that $1 will have grown to $903. Shares are volatile (and so have rough periods – see the arrows) but if you can look through that, they will grow your wealth and that $1 will have grown to $811,079.

Source: ASX, Bloomberg, RBA, AMP

This does not mean blind optimism where you get sucked in with the crowd when it becomes euphoric or into every new whiz bang investment obsession that comes along (like bitcoin or the dot com stocks of the 1990s). If an investment looks too good to be true and the crowd is piling in, then it probably is – particularly if the main reason you are buying in is because of huge recent gains. So, the key is cautious, not blind, optimism.

Finally, even when it might pay to be pessimistic and hence out of the market in corrections and bear markets, trying to get the timing right can be very hard. In hindsight many downswings in markets like the GFC look inevitable and hence forecastable, and so it’s natural to think you can anticipate downswings going forward. But trying to time the market – in terms of both getting out ahead of the fall and back in for the recovery – is difficult. A good way to demonstrate this is with a comparison of returns if an investor is fully invested in shares versus missing out on the best (or worst) days. The next chart shows that if you were fully invested in Australian shares from January 1995, you would have returned 9.3% pa (with dividends but not allowing for franking credits, tax and fees).

Covers Jan 1995 to March 2023. Source: Bloomberg, AMP

If you were pessimistic about the outlook and managed to avoid the 10 worst days (yellow bars), you would have boosted your return to 12.2% pa. And if you avoided the 40 worst days, it would have been boosted to 17.1% pa! But this is very hard, and many investors only get really pessimistic and get out after the bad returns have occurred, just in time to miss some of the best days. For example, if by trying to time the market you miss the 10 best days (blue bars), the return falls to 7.2% pa. If you miss the 40 best days, it drops to just 3% pa.

As Peter Lynch has pointed out “More money has been lost trying to anticipate and protect from corrections than actually in them”.

On a day to day basis it’s around 50/50 as to whether shares will be up or down, but since 1900, shares in the US have had positive returns around seven years out of ten and in Australia it’s around eight years out of ten.

Daily and monthly data from 1995, data for years and decades from 1900. Source: ASX, Bloomberg, AMP

So, getting too hung up in pessimism on the next crisis that will, on the basis of history, drive the market down in two or three years out of ten may mean that you end up missing out on the seven or eight years out of ten when the share market rises. Here’s one final quote to end on.

“No pessimist ever discovered the secrets of the stars, or sailed to an uncharted land, or opened a new heaven to the human spirit”.
– Helen Keller

Source: AMP

The right times for financial advice

By Robert Wright /December 04,2020/

COVID-19 has created uncertainty everywhere and impacted not just our health but our wealth too. From millennials to retirees, we’ve had to review our finances and adapt to the changing environment.

We’ve seen volatile share markets, slashed dividends on bank stocks, record-low interest rates and sectors like airlines, tourism and traditional retail struggling to survive. On the other hand, online shopping and e-commerce have surged, and more people are saving now than before the pandemic.

During this uncertainty, many people have found their financial adviser to be a critical source of guidance and a valuable sounding board. In many cases, the adviser-client relationship has been a long-term connection. It’s built over many years and based on trust and confidence that the adviser has the client’s best interest at the centre of every decision.

Demand for advice doubles

The financial advice industry is full of examples of clients reaching out to their advisers in recent months, leveraging these long-term relationships at a time of worry and crisis.

Recent research from the Investment Trends 2020 Financial Advice Report showed three in four financial advice clients had been in contact with their adviser to discuss the impact of the COVID-19 pandemic.

Advisers are also fielding an unprecedented number of calls from potential clients who are confused by the current markets and understand they need help.

The instability of recent times has undermined the confidence of those who are retired or are about to retire, with many wondering if they’ll be left with enough superannuation savings for a comfortable retirement. But those who have a long-term relationship with their adviser can rely on the fact their adviser knows them well, understands their unique circumstances and life goals, and can deliver advice tailored to them.

Advice for different life stages

Financial advice can be helpful at a range of life stages, not just when thinking about retirement. Some common things advisers can help navigate financially are:

saving for and preparing to buy your first home
getting married or starting a family
budgeting and money management
growing wealth
estate planning
planning for retirement
retirement and aged care.

Advisers can help with practical advice in all these scenarios. But more importantly, they can help you focus on your financial priorities and goals and create a plan to achieve them.

Life’s journey has many twists and turns and points at which priorities change. For many people, it’s a journey best navigated not only with partners, family and friends but with a trusted financial adviser by their side.

Source: AMP

Six steps to building good financial habits

By Robert Wright /November 03,2020/

How financially secure do you feel? Recent research into Australians’ financial wellness – which is a person’s satisfaction with their current and future financial situation – revealed that people with good financial habits feel more financially secure.

It sounds like a no-brainer. But adopting good financial habits isn’t always as easy as it sounds, start building good financial habits with these six steps.

Make your own fresh start

Why do we always start a healthy eating plan or new exercise regime on a Monday? It’s called leveraging the context. And while we find it easier to form new habits during a significant life change like moving house or having a baby, there’s nothing to stop you finding opportunities in your day-to-day routine to instil your new habit.

Review household costs as they crop up. For example, can you reduce the amount spent on groceries when doing the weekly shop? If your health insurance premium is due, check the plan still meets your needs. Starting a new job? Consider if it’s right for you to consolidate your super. By committing to reviewing one thing at a time, you can start building good financial habits as you go.

If you’re now working from home, consider transferring your weekly travel allowance into your savings account each Monday morning.

Piggyback to an existing habit

It’s often easier to tag a new habit onto the end of an existing one. Think about how much easier it is to remember to floss after you’ve brushed your teeth.

When doing your yearly tax return, why not review your financial goals for the coming year?
When it’s time to renew your car insurance, take some time to check you’re getting the best deal from your utility providers too.

Make it easy

If we think something’s going to be hard, we often give up before we start. Keeping it simple and making sure we have the tools to succeed can help.

Tackle one area of your finances at a time to avoid feeling overwhelmed.
Dedicate a consistent time each week or fortnight to do your financial admin and block it out in your diary.
Use technology like banking and budgeting apps and direct debits to make things quicker and more automated.

Cues and rewards

When we start a new habit, it’s important to use cues to remind us to perform the new habit and feel rewarded for doing it.

You might decide to tackle your finances every Wednesday straight after dinner. Then you can reward yourself with a yummy dessert afterwards.

If you’re saving for a new car, you might consider transferring surplus cash from your current account into your new car fund each time you fill up with petrol. You’ll be rewarded with your new car even sooner.

Don’t underestimate the power of ticking something off a list. This simple act can make you feel great.

Practise and repeat

It takes an average of 21 days to form a habit when we’re focused and want to achieve it. Regularly practising your new good financial habits is key to making it stick.

Pop a daily, weekly or fortnightly reminder in your phone or diary. It can help until you remember automatically.

Mentally commit. If we have enough time to be on social media, we have enough time to form good financial habits.

Use meaning for motivation

Think about the meaning behind your new habits to help keep you motivated, both while forming the habit and once it’s part of your routine.

If you’re saving for a house, it doesn’t just mean having your own place to live. It’s creating a home, providing security for yourself and your family into the future, and it shows you have the willpower and commitment to achieve long-term goals.

Likewise, for putting money aside for emergencies. It doesn’t just mean you have the funds to cover a burst pipe. It means you have greater peace of mind and are better protected to weather times of financial uncertainty.

COVID has made us value feeling financially secure, and staying on top of your money can be hard. However, with a little work and commitment to creating good habits, you’ll soon be on the road to taking control.

Source: AMP