Emotional factors such as fear, uncertainty, personal bias, regret aversion and ego, play a much more important role in most people's investment decisions than raw data
Despite efforts to be sensible with our money, research into the psychology of investing shows we are prone to making irrational decisions when it comes to the management of our finances.
According to experts in the field of cognitive psychology, our decisions over money have as much to do with emotional and psychological issues such as fear, uncertainty, personal bias, regret aversion and ego as they do the raw data we receive from the market.
Here we outline five types of irrational behaviour on which many of us base our investment decisions.
We hate losing and take an asymmetrical attitude to risk. When faced with losses, we are less prepared to admit we have made a mistake by selling a lossmaker than we are to hang on to the stock or even buy more.
However, when we experience gains, we take a more benign attitude to risk, boasting of how we bought the stock and it subsequently went up before we sold it. Statistically, we are three times more likely to sell a stock that has done well than a stock that has done badly.
Common sense tells us to run with the winners and sell the losers. It is sensible to hang on to a stock while it is doing well and carry on holding on until we get some sort of signal it might start to perform badly over the long term.
So until there is some evidence of bad times to come, the stock should not be sold.
Of course it is difficult to identify the peak in a stock price and investors rarely succeed in doing this. But the longer we hold onto a winning stock, the better we will do. Even if the stock reaches its peak and begins to fall, it is best not to follow the herd. We should think before we sell.
Similarly, we should not be tempted to double up in a stock that has been performing badly. Empirical evidence suggests that, on average, stocks that have performed badly will continue to do so.
Rules of thumb
When faced with situations in which the consequences are uncertain, such as building an investment portfolio, we employ simple rules of thumb to make the decision-making process easier. For example, many investors decide to buy a stock that has done badly simply by looking at the price it used to be at and assuming one day it will get back up there independently of any proper financial analysis of what the price of the company's stock should be on the basis of valuation parameters. This kind of behavioural bias is sometimes called anchoring.
Some people may buy a stock after a profit warning has caused its price to plummet by, say, 50% in the same day, believing it to be cheap. But if earnings expectations have fallen by more than the price of a stock, the stock in some senses is actually more expensive despite the fall in the share price. Investors should avoid investing in such situations and consider valuations of the company based on the very latest earnings expectations and the price.
Mental compartmentalisation and memory distortion leads investors to forget bad decisions but remember successful ones, skewing an individual's sense of their own aptitude in managing their finances.
Investors should keep accurate and detailed records of all their buy/sell decisions, whether successful or unsuccessful. In doing this, they will be able to make better decisions by learning from and remembering previous mistakes.
Some investors, including professionals, tend to be overly confident in their ability to make the right decision. This extends from many things we do in everyday life.
Surveys in Sweden, for example, show 80% of people thought they were better than average drivers, which clearly cannot be the case. Investors are similarly overconfident about the accuracy of their predictions and do not have sufficient respect for the role chance plays in financial markets.
Investors should realise it is easy to make mistakes in investment and therefore spread bets and manage portfolios in a prudent and objective manner. Learning how to avoid making consistent mistakes is one of the most important lessons portfolio managers and other investors need to learn.
House money effect
This is a gambling term but does have relevance in the world of investment. People in a casino are more likely to bet recklessly with money they have recently won than money they brought into the casino. In stock market terms, this means if an investor has a good run with some investments, he may be tempted to take on a higher level of risk with future investments.
Investors should decide the required risk profile of their portfolio and stick to it. If part of a portfolio yields investment gains, they should try to spread the gain evenly across the entire portfolio rather than allow the riskier part of the portfolio to build up disproportionately to the rest.
Some fund managers are placing increasing importance on analysing investor behaviour when developing investment strategies and trying to exploit the inefficiencies in the market created by the widespread irrational behaviour of investors.
We try to employ a method that avoids the kind of human emotional decision-making traps that lead so many investors whether professionals or amateurs, to make bad decisions.
On the value side, our approach aims to carefully select bargain stocks that have fallen out of fashion, sometimes due to negative media coverage.
A good example of this is so called old economy stocks, which continue to be undervalued because they are seen as dull or unfashionable; prime examples of human behavioural biases creating investment opportunities. With the right catalyst, an undervalued stock can see its share price shoot up.
On the growth side, we aim to buy fast growing companies, but only when the newsflow continues to be good. Again, our analytical model enables us quickly to identify changes in the newsflow from companies, enabling us to ride the winners and minimise investment in previously high-flying growth stocks that turn into 'torpedoes' because of a profits warning or broker's downgrade.
James Elliot is head of European retail funds and joint fund manager of JPMF UK Dynamic Fund and JPMF Europe Fund
Five common psychological mistakes by investors
Regret aversion. We are three times more likely to sell a stock that has done well than a stock that has done badly, while a stock that has done well is likely to continue to do so.
Rules of thumb. Investors may decide to buy a stock without any proper financial analysis of what the price of the company's stock should be on the basis of valuation parameters.
Bad decisions. Mental compartmentalisation and memory distortion leads investors to forget bad decisions but remember successful ones, skewing their sense of their own aptitude in managing their finances.
Overconfidence. Investors are generally overconfident about the accuracy of their predictions and do not have sufficient respect for the role that chance plays in financial markets.
House money effect. If an investor has a good run with some investments, they may be tempted to take on a higher level of risk with future investments.