Critical behavioural errors can dog investment decisions. Here are seven of humanity’s most prominent weaknesses.

At one point in the 1973 movie, Magnum Force, Inspector Harry Callahan (played by Clint Eastwood) uttered the line: “A good man always knows his limitations...” It is important that investors should know their limitations too. Behavioural finance is the study of the influence of psychology on the behaviour of investors. It finds that investors are not always rational, suffer from systemic biases and are limited in their rational self-control.

The first step to combatting these often unconscious biases is to be aware of them. What then are the critical behavioural errors that can dog our decisions? The following errors were identified recently by Joe Wiggins, a fund manager with Aberdeen Standard Investments.

Myopic loss aversion

We are more sensitive to losses than gains and overly influenced by short-term considerations. Often, investors check their portfolios frequently – even if they are operating with a long-term investment horizon. Making frequent investment decisions can worsen your investment results. A 2015 study by the Central Bank of Ireland found that 75% of the retail contract for difference (CFD) clients who invested in CFDs during 2013 and 2014 made a loss.

Integration

We seek to conform to group behaviour and prevailing norms. Like a limping wildebeest at the back of a herd in the Serengeti, we want to keep pace with the herd for fear of being picked off. The problem is that, in investment markets, the herd is more often wrong than right. That is why Warren Buffett said it is wise to be “fearful when others are greedy and greedy when others are fearful”.

Recency

We overweight the importance of recent events. In 2006, one had to look back over a decade and a half to observe a year-on-year decline in Irish residential property prices. Accordingly, most market participants grievously underestimated the possibility of a severe property bear market. Today, memories of the property crash are fresh in people’s minds, and many are fearful of another residential property crash. However, that is quite unlikely with rent yields considerably above mortgage rates.

Risk perception

We are poor at assessing risks and gauging probabilities. We allow the emotional hope of investment gains to override logic in evaluating risks. At the height of the residential property price bubble, houses in some parts of Dublin (such as Howth, Dalkey and Blackrock) were selling for more than 100 times the annual rental income those properties could command. However, many investors were more fearful of missing out on continued gains from the property market despite the dismal long-term return prospects those valuations suggested.

Overconfidence

We overestimate our abilities. Not only is the recorded investment performance of retail investors poor, but so too is the record of professional fund managers. The empirical evidence strongly suggests that the vast majority of investors would be better off buying low-cost funds that track market indices. Nevertheless, millions of us persist with the belief, hope or illusion that we can do better managing our funds ourselves.

Results

We focus on outcomes when assessing the quality of our decisions. Even as the Irish property market got more and more overvalued between 2004 and 2007, and risks continued to mount, investors mostly stuck with it because they were enjoying positive outcomes.

Stories

Captivating stories often persuade us. If you get the chance, watch Alex Gibney’s documentary, The Inventor: Out for Blood in Silicon Valley about the rise and fall of Elizabeth Holmes and Theranos. It depicts the journey of a woman and her company, propelled forward by several captivating stories: replacing injections with thumb-pricks for taking blood samples; replacing an expensive blood-testing duopoly with access controlled by clinicians with cheap tests that individuals could order; having a female entrepreneur enjoy the same success as Apple’s Steve Jobs. But it was all a fraud.

In making financial decisions, it is a case of the forewarned being forearmed: the more we are aware of our limitations, the better we can avoid them.
Cormac Lucey FCA is an economic commentator and lecturer at Chartered Accountants Ireland.