The assumption that human beings always make perfectly rational decisions oversimplifies reality. The theory of the rational economic decision maker that held for more than half a century was flawed, just as we humans are.
Financial advisors that incorporate behavioural finance into their investment decisions help clients feel comfortable with their portfolio and help them understand their personal biases.
Towards the end of the last century the premise that people’s cognition is prone to bias, and far from rational, particularly in times of increased uncertainty, became prominent through the information technology related bubble. Many investors were eager to invest at any valuation, especially if stock had a “.com” in its name. Alan Greenspan (then US Federal Reserve Chairman) coined the term “irrational exuberance” to describe the escalated asset values in 1996.
Despite the smartest minds in finance predicting the bubble would burst (which it eventually did) for years all fundamentals were rejected, and emotion carried the Nasdaq past a price to earnings ratio of 190 (the 10-year average is 22).
In 2002, the Israeli psychologist Daniel Kahneman won a Nobel Prize in Economic Sciences for his work with a colleague, Amos Tversky. They combined psychology with economics and discovered human decisions under conditions of uncertainty depart from those predicted by standard economic theory.
“All rationality is thrown out the window and human emotion and fear skyrockets in times of uncertainty, like the pandemic crash in March this year.”
This insight isn’t a revelation, we all know we’re flawed beings, not models of rational optimization. But in the academic world they only just started to recognize that financial markets are less efficient than first thought.
Emotional biases are usually easy to identify but behavioural economics also looks at the cognitive biases which are much more subtle, yet more common. For example, loss-aversion bias occurs when people tend to strongly avoid losses as opposed to achieving gains. Loss aversion leads people to hold on to non-performing investments even if they have little or next to no chance of going back up. Likewise, loss aversion causes investors to sell their winners at a profit too early limiting their upside.
Overconfidence bias can be seen in the current tech rally. This is where investors believe their particular genius will allow them to get out before the speculation runs its course. History attests, the vast majority are always wrong. Overconfidence is usually unwarranted and has aspects of both cognitive and emotional errors. As a result of overconfidence bias these investors underestimate risk and overestimate expected returns.
There are a many others, such as “recency bias” which is a predisposition that causes people to predominately recall recent events and claim “its different this time!” - these words make market veterans shudder.
An optimal investment portfolio is the one that helps clients obtain their financial goals, whilst simultaneously providing enough security to allow them to sleep at night.
Getting the right investment advice will help you understand your personal biases and let you rest easy.
Should you wish to discuss this or any other investment related matter, please contact our Investment Services Team on (02) 4928 8500.
Disclaimer
The material contained in this publication is the nature of the general comment only, and neither purports, nor is intended to be advice on any particular matter. Persons should not act nor rely upon any information contained in or implied by this publication without seeking appropriate professional advice which relates specifically to his/her particular circumstances. Cutcher & Neale Investment Services Pty Limited expressly disclaim all and any liability to any person, whether a client of Cutcher & Neale Investment Services Pty Limited or not, who acts or fails to act as a consequence of reliance upon the whole or any part of this publication.
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