How investor emotions influence market upturns and downturns

Recent events in global markets have highlighted how investor confidence, emotions and psychology can play a vital role in driving market upturns and downturns.

Recent events in global markets have highlighted how investor confidence, emotions and psychology can play a vital role in driving market upturns and downturns.

Periods of high optimism and soaring markets are generally associated with greed, while falling markets are often powered by fear.

Since the onset of the global financial crisis, many investors have been in the grip of fear, paralysed to act, but not wanting to crystallise losses or make the wrong decision.

The crisis has proven that while the drivers of booms and busts may change, investor behaviour, and its impact on markets, does not.

Recognition of the impact of investor behaviour on markets is becoming an increasingly important consideration in investment management.

Behavioural finance theory had its formal beginnings in the 1980s and became a mainstream economic theory in the 1990s. In contrast to the efficient market hypothesis, behavioural finance deems investors to be irrational, often making investment decisions based on emotions, previous experiences or a fear of regret.

This can result in investors making investment decisions unrelated to the future potential of that investment, causing its share price to trade at a discount or premium to its fair value.

Two well-documented theories relating to investor behaviour are heuristic biases and frame dependence.

Heuristic biases

Heuristics are essentially ‘rules of thumb’ gained from previous experiences that create a natural bias based on that experience rather than on logic.

For example, an investor who lost a lot of money in a single mining stock might never invest in mining stocks again in the belief that their previous experience will be repeated.

There are a number of heuristic biases — two of these, representativeness and overconfidence, are discussed below.

Representativeness

Representativeness bias occurs when investors make decisions based on pre-conceived ideas or stereotypes.

A typical example of this is ‘gambler’s fallacy’, such as when a punter believes that after six heads in a row, tails must be next. Of course, the likelihood of either heads or tails occurring is exactly 50 per cent, but they continue to hold the belief that a change is due.

The problem is the punter is applying a long-term theory over a very short time horizon.

In his book, Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing, Hersh Shefrin uses research by De Bondt and Thaler to show that this representativeness heuristic bias means investors can be overoptimistic about past winners and over-pessimistic about past losers.

This favouritism of past winners and bias away from past losers causes markets to deviate from fair value, with the former becoming overvalued and the latter becoming undervalued.

They also argue that this mispricing is a short-term phenomenon, and over time past losers will outperform the general market and past winners will underperform.

As an example, chart 1 shows the top five performing stocks in 2007 in the energy sector within the S&P/ASX 200 Index.

All five stocks outperformed the energy sector that year. From these numbers, without undertaking proper due diligence, an investor may make the assumption that these five stocks must be of high quality as the market has supported them, and therefore they will continue to outperform their peers.

This was not the case.

In 2008 there was a marked change in performance, with the same ‘basket’ of energy stocks not only significantly underperforming the sector’s benchmark that year, but the performance between the stocks varying dramatically, ranging from -86.3 per cent (Strata Resources) to +15.4 per cent (Centennial Coal).

Looking at the past performance of a particular asset class is also a form of representativeness. But this approach is also a flawed strategy.

If an investor invested in each previous years’ best asset class over a 20-year period, an initial investment of $10,000 in December 1988 would have been worth $32,374 in December 2008.

This is significantly less than the $50,862 return if the investment was in a typical balanced fund where the asset allocation was fixed over the whole period.

Overconfidence

Another heuristic bias that can influence the way people make investment decisions is overconfidence.

When investors make a number of successful stock picks, overconfidence creeps in and their desire to trade more increases.

While this may or may not lead to higher gross returns, the increased trading activity generates higher trading costs (brokerage) and hence may result in lower net returns than a ‘buy and hold’ approach.

For Australian investors there are also tax implications for stocks held for less than 12 months.

The link between over-trading and reduced net returns was explored by Brad M Barber and Terrance Odean.

Their analysis, which was based on around 66,000 households in the US with accounts at a large discount broker between 1991 and 1996, showed over-trading had a huge impact on net returns.

Households that traded frequently earned a net annualised return of 11.4 per cent over the five-year period, while those who traded infrequently earned a much higher annualised return of 18.5 per cent.

One way for investors to reduce their susceptibility to many of these heuristic biases is to invest with professional fund managers. Their use of valuation models, disciplined processes and extensive company visits help to reduce the emotive element from the decision-making process and determine the true price of a stock or security.

Frame dependence

Another area within behavioural finance theory that can help explain irrational investor behaviour is frame dependence. This concept centres on people having ‘frames of reference’ when making decisions, particularly when it involves risk or uncertainty.

An easy way to think of ‘frames of reference’ is to picture several compartments in your mind for different pots of money.

Gambling can be an example of this. A punter bets $10 in poker and wins $50. In their mind, the original $10 is the amount that goes in the ‘can’t lose box’ and hence back into their pocket, while the $40 goes in the ‘can lose box’ and stays in their hand.

After all, the punter didn’t have the $40 at the beginning of the night (and hence sees it as ‘free’ money) and is happy to take high levels of risk with that money.

By allocating the $50 between two pots in their mind, the punter fails to make logical decisions.

In this example, the punter should look at their total money as if it is in one pot ($50) and decide how much they wish to risk. This action is likely to result in the punter making more conservative decisions.

This behaviour can equally apply to investing. Investors often focus on the initial capital outlay as the amount ‘at risk’, rather than the accumulated value over time.

For example, an initial investment of $10,000 rises in value one year later by $1,000. Investors may regard the amount of money at risk as being the initial $10,000, but really the total ‘at risk’ money is $11,000.

It is this total amount invested that the investor should be constantly re-evaluating when making investment decisions — whether it is to invest more, redeem or switch to another fund/asset class.

Regret

Another area that falls under frame dependence is regret. The key underlying premise for this behaviour is an investor’s fear of incurring losses.

Studies by Daniel Kahneman and Amos Tversky have shown that investors feel a loss two and half times more strongly than a gain of the same amount. They call this phenomenon ‘loss aversion’.

This fear of making the wrong decision often means investors don’t assess risk correctly — they tend to overemphasise risk, which can actually lead to wrong decisions or inertia.

Investors need to ask themselves which risk is greater: the risk of making a decision that could lose them money, or the risk of missing out on an opportunity that could make them money.

Studies have shown that people tend to have the highest level of regret for actions they didn’t take rather than actions they did take.

One example of regret is investors’ difficulty in selling a losing stock. The feeling of regret is strongest when the loss is crystallised — until that point the investor holds out hope the stock will return to its ‘former glory’ and avoids generating feelings of regret by holding onto it.

Another aspect to this is that if the investor made the original investment decision alone, the feeling of regret is much greater than if they were following someone’s advice.

It’s not so much about the pain of making a loss, but rather the pain of being responsible for making the decision.

This could explain why investors sometimes find it easier to outsource their investment decisions (ie, to a financial adviser). Apart from needing professional advice, it also means some of the burden of making decisions is shared.

By contrast, professional fund managers acknowledge and seek to control this behavioural risk.

This is largely through their disciplined processes, which allow them to assess the relative merits of investing in particular stocks and make relatively unbiased decisions; if selling a losing stock is the right decision, the framework will be in place to allow that to occur.

The fear of regret often leads to inertia in making decisions. This could be one of the reasons why around 80 per cent of Australians have remained in the ‘default’ fund in their superannuation plan.

As this tends to be a balanced fund, this could mean a significantly lower superannuation payout on retirement than if invested in a higher growth option over an individual’s working life.

Not making a choice, therefore, potentially exposes investors to greater risk — they are swapping the risk of losing money with the risk of not having enough money in retirement.

Emotion and the human psyche are indeed powerful forces, often leading investors to make irrational decisions or, sometimes even worse, not making any decisions — both of which can be detrimental to the long-term performance of their investment portfolio.

The recent turmoil in the global financial markets has highlighted two of the most extreme emotions — that of greed followed by fear — with ironically the former playing a role in causing the latter.

By removing these emotions and psychological behaviours from the decision-making process, investors are in a better position to make logical and rational decisions.

Seeking professional investment advice from a financial adviser, taking a long-term view, constructing portfolios based on an investor’s risk/return profile and investing with professional fund managers are steps an investor can take to help them achieve this.

Craig Hobart is head of retail for Tyndall Investment Management.