Chamber of Commerce Magazine Articles
We all like to think we are rational beings when surveying the irrational behaviour of others. Most financial theory reflects the idea that each investor carefully considers all available information, in a rational way, before making investment decisions. There is however much evidence which shows this is not necessarily the case. As one investment manager puts it – if you sit down at a poker table and can’t spot the sucker who will be taken that night, get up – it’s you!
Behavioural Finance, a study of investment behaviour, draws on psychology in an effort to show why people buy or sell when they do, – or why they don’t buy at all. This research into investor behaviour helps to explain the various market anomalies that challenge standard economic theory. The key ideas in behavioural finance include prospect theory, regret theory, anchoring, and over or under reaction.
Prospect theory suggests that investors react differently to equivalent situations, depending on whether the likely result appears as a potential loss or a potential gain – a bit like the half full/half empty glass attitude. Typically, we become much more distressed at the prospect of a loss, than happy by equivalent gains. Casinos know this – above the pokies we see the potential prize, not the far more likely loss ratio. “Loss aversion” means that investors are willing to take more risk to avoid a loss, than to realise a gain. In fact, faced with a sure gain, most investors are risk averse, but faced with a sure loss they become risk takers. According to the related “endowment effect,” people set a higher price on something they own than they would be prepared to pay to acquire it. If this sounds a little to far-fetched to you, consider, in a rational way of course, the price you would place on your home and compare that with price you would pay to purchase it. Regret theory relates to investors emotional reaction to having made an error of judgement, whether it was investing in a portfolio which has plummeted or not investing in one which they had considered and which has subsequently gone up. Or to put it simply, selling at the bottom of the market, or buying at the top – typical investor behaviour! Investors have reported avoiding selling when values have gone down to avoid the regret of having made a bad decision and the embarrassment of reporting the loss. It may be easier to follow the crowd – if you have subsequent loss it can be rationalised as everyone else did the same. Going against conventional wisdom is harder since it raises the possibility of regret if decisions prove incorrect
Anchoring is a phenomenon in which investors assume current prices are about right. We saw this in the not too distant past – each new high during the 90’s bull market was anchored by its closeness to the last record, we have had the same response to the current bear market – each new low brings with it the expectation of a further low. Writing this three days into the invasion of Iraq, with new highs being anchored each day over the last weeks, our expectations change even without examination of economic trends. Investors tend to give too much weight to recent experience.
The theory of over or under reaction probably needs little explanation – investors tend to put too much weight on recent news; investors show overconfidence – becoming more optimistic when the market goes up and more pessimistic when the market goes down. Then prices fall too much on bad news and rise too much on good news.
Two psychological theories underpin these views of investor behaviour the “representativeness heuristic” where people tend to see patterns in random sequences, for example in financial data. The second “conservatism,” is where people chase what they see as a trend but remain slow to change their opinions in the face of new evidence that runs counter to their world view.
So you say, this academic theory is all very well how can it be of practical help? Two sides of the coin (sorry about the pun), financial criteria and approach need to be integrated for you to be an effective investor. The strategies that are the most profitable are a result of successful investors being able to accept any behavioural tendencies they have and invest accordingly. If you are unable to do this, your financial plan can turn to custard. You may start out with the best intentions but irrational motives, misperceptions and beliefs can lead to poor decisions. Here are some of the errors investors make:
* Investors may overestimate skills attributing success to ability
they don’t possess, seeing order in information or data where
it doesn’t exist, or distort information to add weight to their
* Investors are often unable to alter beliefs, falling in love with their investments, remembering their successes and forgetting failures.
* Avoiding risk when there is a chance of a certain gain but when faced with loss become risk takers – the loss of a dollar is felt more keenly than the profit of a dollar.
* Investors often make a distinction between “hard earned money” and “found money,” that is found money is more easily put at risk.
* Investors tend to think in extremes, taking short term views – losses lead to suspicion and caution while recent gains lead to action.
* Investors often assume that lack of market movement represents stability while volatility represents instability.
* Investors follow the crowds, are heavily influenced by other investors or compelling news.
* Fail to check facts and make predictions based on limited information.
Overall these errors really have one effect, especially when uncertainty,
inexperience, attitudes and market pressures come together, they undermine
decision-making ability. The way to overcome any possible problems is
to implement a good investment strategy, with an exit plan ,if you feel
you need one.
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In 1995 the Prime Minister of Pakistan addressed the UN Conference on womens, she said that women cannot control their lives and make their own choices until we have financial independence – economic equality. International institutions such as the World Bank, acknowledge that there is a growing body of evidence which clearly demonstrates that economic inequality is bad for economic development generally.
For generations as we know women’s financial lives have been dependent on that of men. Many of us were brought up to think that there was some benevolent father god watching over us, handing out goodies to well behaved girls. Despite this however, many women are changing their attitudes to business and to investing. Women entrepreneurs are starting companies at twice the rate of men, moving into construction, transportation, agricultural and manufacturing services. American owned businesses generate over 3 trillion annually and employ almost thirty per cent of all US employees. Close to home New-Zealand women are setting their own records.
In the investment world we are even starting to better men in some areas. New research shows that women’s portfolios gained 1.4% per year more than men’s portfolios in a study which spanned from 1991 to 1997. In fact single women did even better than single men gaining 2.3% greater returns on their portfolio.
A separate survey of investment clubs produced similar results. Women excelled over men. The ten-year investment study showed that all female investment clubs outpaced all male investment clubs, with a 23.8% averaged compounded annual return, compared to 19.3% for the male clubs. Obviously these surveys did not include the last rocky period. The figures per se are not as important as the message they convey. We are able to use our innate skills to secure our financial futures. So what are we doing that’s right?
Women look at more than just the numbers. As a response to the math anxiety and lower confidence in our financial prowess we make investment decisions based on our life experience. In choosing an investment we consider issues such as the quality of the product – we are comfortable with buying quality – we are good at that. One survey found that women can spend up to 40% more time than men on researching and we are much less likely to act on a hot tip.
Women take fewer risks nearly 32% of women labelled themselves as conservative investors compared with 22% of men – this translates into not chasing high returns but implementing a strategy rather than chasing market cycles. In fact, men traded an impressive 45% more than women. The survey showed also that women have less confidence in their investing abilities only 55 per cent of women felt confident versus 65% of men.
A recent survey on women and retirement however made more sobering reading. Over 33% of women surveyed avoided making financial decisions through fear of making a mistake, often deferring making financial decisions and leaving money management to the men in their lives. In addition only 27% of women were willing to take substantial financial risk for substantial gain – versus 42% of men. This can be a drawback as in long term investment some risk is essential for capital gain.
We are not doing so well in the accumulation stakes - Men report more than double the current savings amount towards retirement, this same pattern holds true when projecting the amount women expect to have saved by 65. Currently women’s retirement income is around two and a half times less than a man’s furthermore women are more likely to be unsure of the amount they have saved for retirement.
So dear reader where does this information lead us. We are obviously more than capable of investing, understanding markets and implementing appropriate financial strategies. On the whole we probably are not taking enough risk in out portfolio and some of us are even reluctant to face money and investment. We are now witnessing the return of the economically powerful woman – but we may be more tentative when it comes to investing for retirement. Still we have a growing edge over men when it comes to cultivating positive attitudes about work and later years.