Emotional biases in investment decisions

Introduction:

In an article published in the Harvard Business Review of March 2017 called "Air pollution brings down the Stock Market", professor Anthony Heyes from the Universitity of Ottawa and his team underlined a clear link between air pollution and performance of the market. In a rational world, were all decisions are taken after analyzing data, they discovered that even professionals are influenced by their environment. Therefore, imagine how private investors can be influenced by emotions in their investment decisions.

This article is not a scientific research but we will explore the different emotional bias that private investors can face.

Following the herd:

Human is a social animal. It means that for adaptive reasons we like to follow what others are doing. To highlight that principle, this is what Bertrand Russell philosopher and mathematician father of Conrad Russell said:

«Collective fear stimulates herd instinct, and tends to produce ferocity toward those who are not regarded as members of the herd."

Consequently, imagine the social tension a human has to live with, when he thinks differently from the her

After this short introduction let’s adapt this behavior to the market. Remember the past, in the ‘90s we discovered the so called new technologies, in abbreviation : TMT’s (for Telecoms, Media, and new technologies). Even though people used and wrote a lot about this new market most of the people didn't invest in the Nasdaq in the early stage of the '90s. In 1995 the index was at 1.000 point and reached 5.000 points (X5) in 5 years’ time. Most of the investors came into the market in 1998 and 1999 when the most representative tech index had already ..tripled.

For rational reasons: massive investments in techs for the so called Y2k bug - Internet became more popular mid-'90 ties - IPO's phenomenon, remember the introduction of Netscape, they started at 28 USD in the morning and finished at 75 USD after the first day on the Nasdaq. But it was not totally rational because everybody knew that the market was overvalued. The Nasdaq exploded the roof of 100 P/E (Price vs Earnings) and even reached 175 P/E in 1999. In comparison, today the Nasdaq is valorized at a Price earning of 26,1 after a very favorable period of increase!!! What pushed people to invest when the market was too high? Of course, it’s because of the herd behavior, you remember maybe friends that told you that they were in a winning game and to be a precursor and as smart has him you had to invest in those stocks, because of a market that increased constantly during 5 years, because banks showed huge performances in their techs mutual funds and has we all know today past performances does not guarantee future results. But the market was dramatically overvalued and people that didn’t followed the herd but followed the figures knew that the crash was nearby, we called them contrarian investors. Contrarian, because they don’t follow the herds, they follow their figures. The bubble exploded in 2001 a first time through the 9/11 and then in 2002 due to different cases like Enron and Worldcom in the US. In Belgium we badly experienced Lernout & Hauspie, France Vivendi driven by Jean-Marie Messier also known as J6M, Sweden with Ericcson etc etc etc..

The financial chart of emotions:

As an extension of the previous topic, neurosciences linked to investment discovered this well known chart representing the investment decisions linked to our emotions.

If you listen to your emotions, you'll never invest when the market are at a bottom, but most of us will invest in a period of euphoria when the markets are going up, in stocks that performed better. It's a big error, because in this case you take decisions only throughout the spectrum of your emotions, based on fears and exaltation but not on an rational analysis. It's admitted by wealth managers that market timing will never be your best friend. In french there is an adage called: "acheter au son du canon, vendre au son du clairon" (buy when you hear bad news and sell when you hear good news) which is probably the best answer to this scheme when you are overcome by your emotions during periods of high volatility in the markets. In my profession there is a very good indicator when the market is ready for a rally. Usually, two to three days before that point of inflection most of the people are abdicating and sell all their positions. I experienced that in 2001, 2002 and in 2008 (even though my experience is not statistically representative). Be sure it’s the moment before the market will recover, and fast!

Will-O'-the wisp (Madoff's experience):

This point need probably a complete article. In 2008, the whole planet discovered that the former chairman of the Nasdaq, Bernard Madoff, the one that through his wealth management company scammed 4.800 clients for 64,8 Billion $. Based on the Ponzy scheme (in 1920 Charles Ponzi became notorious through a well-known fraud by offering higher returns to new investors in order to pay the earlier investors and ...himself). Bernard Madoff in view of his reputation, this well-known wealth manager ripped-off investors that thought, through false documents, that they had the privilege to participate to impossible well-above average returns. Imagine someone, well known offers you the privilege to participate to a constant 10 % annual return business. Everything was false but most of those investors considered to be chosen as privilege stakeholders couldn't imagine that this “Guru” was just a ...merchant of dreams. Above the Ponzy scheme, it's without any doubts a psychological case that we have to point out. Rationally it's seems impossible to invest in that kind of investment, but human soul is not only rational. You create a dream, inaccessible for most of the people, you put a charismatic Guru in the mixture and then you tell investors that they have the privilege to participate to this impossible dream and you have a Madoff case.

Critical analysis of Success Stories :

Who never heard that: "One of my friends realized a huge return thanks to an insight information" or "I know someone that makes each year on average a performance of more than 10 percent"

This topic is linked to the previous one, although this is not a Will-’O-Wisp case, but it’s also dangerous to listen only to success stories. They will probably never tell you when they failed, most of the time they will only talk about their victories!

Confusion between short term and long term investment:

My experience has shown me that for some private investors it could have a confusion between short and long term investment. And a lake in that analysis could cause during periods of high volatility many fears for them, pushing investors to take the wrong decision. In other words, if you know that in the coming months you’ll have some expenses don’t invest that money in the stock market. As a professional we will advise people to have a clear view on their short, mid, and long term needs. This assessment will avoid a lot of future troubles with their cash management.

People are looking for a confirmation of their thoughts:

When someone is interested in an investment solution, usually he compares information’s in order to take his decision. This is logic. Yes, but that's a pure analytical point of view. Like for the other topics we, as humans, forget sometimes that we are driven by emotions.

Imagine, your smart friend, yes the one that's very successful, the one that has a big car, the perfect family and a...dog (yes that guy has most of the time a charming dog). So, imagine that friend telling you, hey Max (yes I call you Max) :" I've heard from my family officer that this fund managed by a famous guy will have in the coming months a very impressive return, thanks to their decision to invest in the water market......".

How will you react? Probably, you'll start to “Google” the name of the fund, maybe the name of the fund manager and probably look at their participations. Then, because you are smart, you'll look at the evolution of the water price. To be honest you don't know anything about that market, how do they fix the price? who are the most important distributors? what does affect the evolution of the demand? etc.). You'll fix your attention to the information that your friend told you and you'll take your decision based on the data that you discovered on internet. But you'll probably not look at some details that make the difference. What's the P/E* of the water market? who are the people or the company's that influence the market? Did the fund manager already took positions? Did he sell them since you get the info? What do the other fund managers think about the water market? Why did some of them refuse to invest in that particular segment?

Trent Porter a US financial planner said about this topic:

"Oftentimes, it happens when we attach an emphasis to the outcomes we desire, such as investing too much in the stock of the company you work for, which also reduces your diversification. The best way to overcome this bias is to consider information from multiple sources"

Source of money (making by myself or inheritance):

As a private banker, I discovered that through number of discussions with private investors, they are doing a clear distinction between money they make by their own work and money received by inheritance. This bias can influence investment decisions. During financial planning discussions, they usually say about money they “received” that they don’t want to “lose” it and only collect the revenues. When interest rates were at a high level, this was not really a topic of discussion, but now that the rates a very low (0,10 % on average in Belgium on a saving account) they have some psychological troubles to take more risk with that money, and are losing money on a real rate basis (interest rate vs inflation = 0,10 % (savings) and 1,8 % inflation on average on the Eurozone). That’s why now it’s common to say: “we don’t earn money anymore”. Yes, but specifically, no more in cash or in bonds (it was in the past decades also the case but because the interest rates were higher, they didn’t really compare it to the inflation, the reality is different as the instinct). Or another common sentence “banks don’t bring money anymore to their clients”. It’s a common sense, but this is not totally stemed from their banks, it’s much more complicated than that. Since the financial crisis, banks have to follow strict solvency rules in order to avoid (try to) a new bank crash. Besides that, short term rates (fixed by ECB = European Central Bank) are negative, which means that bank are losing money when they provide a 0,10 % positive rate on their savings account.

Conclusions:

Through those different topics, I try to show… rationally that investors take decisions through the prism of their emotions. Which is a paradox...therefore most of the institutional intermediaries try to find rational solutions for their clients through the strict application of EU rules (like Mifid) but they have also to consider that “we are only human after all”, like Rag’n’ Bone try to explain in his famous song. It means that your financial planner is still very usfeful to inform you properly about those topics. Don't hesitate to foward this article and to provide your inputs, they are welcome.

Sébastien Van Passel - Twitter : @sebvanpassel

Sources :

· Scott Berinato, “Air pollution brings down the Stock Market” Harvard business Review, March-April 2017;

· Air Pollution Brings Down the Stock MarkeAir pollution brings down the Stock Market by scott Berinato -Harvard Business Review march – april 2017

· David S. Scharfstein, Jeremy C. Stein “Herd behavior and Investment” The American Economic Review, Volume 80, Issue 3 (Jun., 1990) 465 -479 http://econdse.org/wp-content/uploads/2013/04/herd-scharfstein.pdf

· Satish Kumar Nisha Goyal , (2015),"Behavioural biases in investment decision making – a systematic literature review", Qualitative Research in Financial Markets, Vol. 7 Iss 1 pp. 88 – 108

· Kate Stalter in Money US News : 26 may 2015 “7 Behavioral biases that may hurt your investments” : http://money.usnews.com/money/personal-finance/mutual-funds/articles/2015/05/26/7-behavioral-biases-that-may-hurt-your-investments

· Rahul Gupta, 16 september 2014 “Effects Of Behavioral Biases In Investing Decisions” http://www.investopedia.com/articles/investing/091614/effects-behavioral-biases-investing-decisions.as

Glossary:

*The price-earnings ratio (P/E Ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings. (Investopedia)

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