Curmi & Partners

The Psychology of Investing

By Matthias Busuttil

Investors are faced with a barrage of information when deciding on where to invest their capital, or whether to buy or sell an investment, and with limited time to think about it. Investment decisions involve complex situations and require significant time and effort to be able to arrive at a completely rational solution and develop the most optimal course of action.

While traditional theory points us towards what one should do to arrive at an optimal decision, what actually happens is somewhat different. The human element plays a bigger role in breaking down a complicated problem into simpler components in order to arrive at an answer. However, this comes at the cost of accuracy and objectivity as the individual swiftly drifts into a more subjective path of reasoning.

This subjectivity is characterised by behavioural biases. These biases broadly take the form of either the systematic selection of an incorrect outcome or a preference or inclination that restricts impartial judgement. These two types of behavioural biases are referred to as cognitive errors and emotional biases.

Cognitive errors can be described in general as faulty reasoning. That is, arriving at an incorrect conclusion due to defective computational capability. The first form of cognitive errors is the tendency of individuals to hold on to previously held beliefs and justify their conclusion through incorrect information processing or memory error. This occurrence is driven by an underlying mental conflict when an individual is faced with information that contradicts his current beliefs.

One practical result is conservatism bias, which is when individuals fail to integrate new information and maintain their existing views or forecasts. For instance, an investor buys a stock based on the belief that the company will experience growth through a new product launch.  However, the management announces that the company is experiencing difficulties with the development of the new product which may delay its roll out and increase manufacturing costs. The individual may discount the new information and fails to recognise its negative impact and decides to hold the stock based on his prior belief about the company.

Cognitive errors may also be in the form of processing errors. This occurs when information is processed and used illogically. A typical processing bias is the “availability bias” whereby individuals overestimate an outcome based on how easily such outcome comes to mind - what is more personally relevant, more recent or dramatic. For instance, investors often overreact to news flow and, as a result, equity or bond prices overshoot on the way up or drop too low on the way down.

The second type of behavioural bias is emotional bias. Emotional biases are in general defined as reasoning which is influenced by emotion, intuition or impulse. These influences represent irrational inputs in an individual's decision-making process which also lead to subjective and sub-optimal conclusions.

Perhaps the most common of such biases is loss-aversion bias. This refers to an investor's tendency to strongly prefer avoiding losses as opposed to making gains. Put differently, a one unit of loss means more to a loss-averse investor than a one unit of gain. The result of such bias is that investors tend to hold on to losers even if the prospects of the investment are not positive. On the other hand, loss-aversion bias drives investors to take profits quicker and sell good investments too early as a result of undue fear of losing unrealised gains.

Another common emotional bias is "endowment bias". This occurs when people place a higher value on an asset when they hold it than when they do not. In other words, an individual would ask for a higher price to sell an asset which he holds than he is willing to pay for it if he did not. Endowment bias is often evident in individuals who inherit investments from a deceased relative. Such bias is manifested in the person’s reluctance to make changes to the investments even if the investments are not suitable for the individual’s risk profile and investment objectives.

These behavioural biases tend to sway an investor’s decision making process resulting in personal or illogical conclusions which lead to sub-optimal investment choices. It is often easier to attempt to correct cognitive biases as opposed to emotional biases. This can be done through more education on investment decision making and portfolio management techniques. However, adjusting for emotional biases involves a deep level of detachment between the decision maker and the investment portfolio while requiring the decision maker to maintain full interest in achieving the desired results.

 

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.