Investor Psychology

It's hard not to think of the stock market as a person: it has moods that can turn from irritable to euphoric: it can also react hastily one day and make amends the next.

Generally it used to be only the “realists” that saw the true picture, but nowadays information is difficult to decipher. Especially when its presented and pitched in four letter vocabulary at the level of an 8-year old. How can one Trump that? Herd instinct explains why people tend to imitate others. Behavioural finance theorists say that psychology really helps us to understand financial markets.

Tenets and Findings of Behavioural Finance

This field of study argues that people are not nearly as rational as traditional finance theory makes out. For investors who are curious about how emotions and biases drive share prices, behavioural finance offers some interesting descriptions and explanations. The idea that psychology drives stock market movements flies in the face of established theories that advocate the notion that markets are efficient.

Proponents of efficient market hypothesis say that any new information relevant to a company's value is quickly priced by the market through the process of arbitrage. For anyone who's been through the internet bubble at the start of this century and the subsequent crash, the efficient market theory is pretty hard to swallow. Behaviourists explain that, rather than being anomalies, irrational behaviour is commonplace. In fact, researchers have regularly reproduced market behaviour using very simple experiments. Let's look at how the average person behaves when incurring financial Losses versus Significant Gains on his investments.

Here is one experiment:

Offer someone a choice of a sure R50 or, on the flip of a coin, the possibility of winning R100 or winning nothing. Chances are the person will pocket the sure thing. Conversely, offer a choice of a sure loss of R50 or, on a flip of a coin, a loss of R100 or nothing. The person will probably take the coin toss. The chance of the coin flipping either way is equivalent for both scenarios, yet people will go for the coin toss to save themselves from loss even though the coin flip could mean an even greater loss. People tend to view the possibility of recouping a loss as more important than the possibility of a greater gain.

The hypotheses indicates a full mediation effect of investors’ self-reflection on the relationship between their experience and herd bias. The experiences are to be cognitively reflected to yield learning to reduce behavioural biases.

Nowadays investors are more interconnected and networked than ever and as such, are prone to herd behaviour. In investing, the herd is often driven to get-rich-quick schemes, which can lead them to buy overpriced shares. Investors think they know something that the market doesn’t. When a market is moving up or down, investors are subject to a fear that others know more or have more information. As a consequence, investors feel a strong impulse to do what others are doing. This leaves them susceptible to behavioural biases which often translates to buying high and selling low – not a formula for long-term prosperity. Trying to time the market leads to constant trading or switching between unit trusts. Mr “Market” is random and inherently unpredictable thereby timing the market is extremely difficult to do.

The uncertainty of market conditions causes investors to reduce their risk appetite. As a consequence, a lower level of interactions with their investment advisors results in an absence of learning effects from their relationships with the advisors. The success of an investor is highly dependent on the ability to learn and adapt to dynamic market conditions with feasible investment strategies. Lack of knowledge is probably the main reason why investors invest recklessly. The more knowledge, the higher the risk a client would be prepared to take and, therefore, also the higher the potential returns would be.

Unadvised investors are inclined to purchase the most expensive investments of the best-known companies, get caught up in fads and fashion, and to follow the herd, rather than looking at investments with long-term intrinsic value. If you don’t know enough and don’t have time to do your own analysis, rather increase your financial advisor interactions and get advice. Not just anyone however - at a minimum your financial advisor should have followed a postgraduate program in Financial planning which is accredited by the Financial Planning Institute of Southern Africa (FPI).

Of course, there are times when changing from one investment to another is a good idea. There are three main prompts:

• If your objectives change.
• If you have lost faith in your fund manager's performance.
• If the fund has changed.

Our integrated wealthcare approach is based on your personal priorities and aspirations. This process is designed to give you a clear course of action for pursuing your goals that span various time horizons and life stages to empower you to do extraordinary things with your wealth, both now and in the future.

Regards,

Shane Thom, CFP^® GTP(SA)™
Managing Partner: Integrated Wealthcare Advisor