“The investor’s chief problem—and even his worst enemy—is likely to be himself.” - Benjamin Graham
While traders may strive to buy low and sell high, emotions may drive them to do just the opposite. Feelings such as fear, loss, and greed can play a large role in our investment choices. In fact, there is a field devoted to the biases and heuristics that investors face called Behavioural Finance.
Think of the last time you experienced a market upturn. Chances are you checked your accounts more often, to view your gains. In fact studies have shown that investors who have recently gained money check their accounts more than investors who have recently lost money. This is true even for our checking accounts, on paydays we are 62% more likely to log into our bank accounts. We like to see good news and avoid experiencing loss.
The stock market can be volatile, and when there is a down-turn, the feeling of loss can negatively impact rational trading decisions. It's difficult for humans to manage our emotions even when we are aware of its impact. It's possible for investors actively managing their accounts to underperform compared to the market. It is likely that these investors were making bad decisions due to their emotions.
In the field of Behavioral Finance there is debate as to the emotions that impact investors, one camp argues it’s only fear of loss that is the driver of irrationality while others name greed and fear as the competing emotions. It is also argued that reducing investor emotions to one or two feelings is too reductive. Regardless of the emotion itself, it is well understood that emotions do play a large role in our choices. Investors, like all humans, are subject to their emotional associations that shape their actions.
Here are 3 key heuristics that investors should be aware that can impact their emotional state and lead to suboptimal outcomes
1) Gambler’s Fallacy
Trading and gambling are different, yet when traders make bad decisions they can begin to adopt a gamblers’ mentality and revert to similar heuristics that result in suboptimal decisions. The gambler’s fallacy comes from the idea that a certain event is more or less likely, given a previous series of events. For example, if you are sitting at a roulette table and have seen the wheel land on red for three times in a row, you are likely to bet on black because you feel that the ball is “due” to land on the different colour.
The problem with this fallacy is that it is based on an incorrect understanding of probability and risk. This can be illustrated by a coin toss example. While it is unlikely for a coin to land 10 times in a row on heads, if a coin is tossed 1,000 times, there is a very high probability that it will at one point land on heads 10 times in a row. This is because we can misunderstand the probability of an event occurring when it is not independent of other events. Small probabilities can still happen particularly when they are tested many times.
With the gambler’s fallacy, we tend to feel excitement and a false sense of security about an unsure probability. This emotion then can influence our investing choices - leading to riskier decisions under a false sense of security.
2) Overconfidence Bias
Additionally, we tend to overestimate our abilities, and attribute our success to internal factors. A famous study found that 93% of adults in the US rated themselves better drivers than average. This overconfidence on the roads leads to drivers being more aggressive as they believe they are better than they are - thus they feel a false sense of safety. In investing, this bias can also lead to negative outcomes.
Studies have shown that overconfident investors attribute their success to their skill and discount any luck having to do with their investment gains. They are more likely to underestimate risks and trade excessively. Barber and Odean researched over 78,000 US brokerage accounts over 6 years. Over that time, there were over 3 million trades. They compared the investment returns for the 20% of investors who made the most trades and the 20% who traded the least. The 20% of confident, frequent traders achieved significantly lower annual returns compared to the less active traders.
Overconfidence is another bias that leads to a feeling of a false sense of security. Investors feel overconfident in their own abilities and are likely to make more trades which often leads to riskier choices and lower returns per annum.
3) Recency Effect
Finally, the recency effect is another bias that can lead to investors making suboptimal decisions. As humans, we tend to make predictions on the future based only on the recent past. This is a bias based on our memories, and the more recent past tends to be more salient to our judgements. For example, it has been found that employee evaluations are often more highly rated by a recent project than a full picture of a year. This can miss important information about someone’s actual performance throughout the year and lead to a more negative or positive review.
This bias tends to disrupt investor’s emotions after a market crash. In 2008, during the financial crisis, survey data found that the stock market performance was made even more volatile due to investor trading behaviour. This is because investors were basing their investment decisions on recent performance. This can lead to suboptimal choices because like in the employee evaluations investors are not looking at all relevant data to support their choice.
Unlike the first two biases, the recency bias can work with investors’ fear of loss. They can be hesitant to act which can ultimately miss out on a great opportunity.
Emotions can make us feel more secure in our choices and push us to hastily trade more, or fearful of the market and make us hesitant to act. Either way, these feelings can make investors choose suboptimal trades for themselves and their clients.
So how can Investors avoid the impact of emotions on their choices? As humans we cannot avoid our emotions. However, when investors are making a decision it can be safer to avoid large trades, where overconfidence of a large monetary gain or fear of a large loss can be more impactful. Instead, slowly selling off assets or reducing the number of daily trades can help investors to avoid any emotional mistakes.
Arvid O.I. Hoffmann, Thomas Post, Joost M.E. Pennings, “Individual investor perceptions and behavior during the financial crisis”. 2013. Journal of Banking & Finance, 37.13. Pages 60-74, ISSN 0378-4266.
Barber and Odean. 1999, "The courage of misguided convictions". Association for Investment Management and Research.
Bouteska, A. and Regaieg, B. 2020, "Loss aversion, overconfidence of investors and their impact on market performance evidence from the US stock markets", Journal of Economics, Finance and Administrative Science, Vol. 25 No. 50, pp. 451-478.
Hirshleifer, D., & Luo, G. Y. 2001. On the survival of overconfident traders in a competitive securities market. Journal of Financial Markets, 4(1), 73-84.
Ola Svenson, "Are we less risky and more skilful that our fellow drivers", Acta Psychologica