Money: Hot heads rule, not cool logic

By BRENT SHEATHER

Back in the 1960s and 70s, theories which explained the workings of the sharemarket in thoroughly rational terms were embraced as the best thing since flared pants.

Lately, though, the idea that sharemarket investors are deadly rational has come under challenge.

As last week's Weekend Money pointed out, that challenge comes from followers of "behavioural" economics, a school which says many investors are in fact irrational. Not only that, they are irrational in predictable ways - too confident, too optimistic, too prone to self-delusion.

This may be interesting, but what use is it to anyone trying to make the right investment decisions?

A new book, Beyond Greed and Fear, by US finance professor Hersh Shefrin, answers that question by pointing out some of the most common weaknesses investors display. If we are aware of those weaknesses we can use that knowledge to make better investment decisions.

Of course, the disciples of rational markets would argue that if too many investors buy Shefrin's book, the anomalies he highlights will disappear, but let's not go down that road.

Here are some of the key lessons from Shefrin's guide to the new economics:

Avoid over-confidence


Shefrin reckons over-confidence is one of the best-documented behavioural biases and a prime reason for poor investment decisions.

Researchers have found that one of the reasons investors are reluctant to sell loss-making investments is that it requires them to admit a mistake, which could lead to a loss of confidence.

For the same reason, investors pay more attention to information which supports their views, and filter out conflicting reports.

Further evidence suggests that over-confidence influences investors' judgment more when they are analysing vague, subjective information (high-tech shares spring to mind), whereas the pricing of stable, existing businesses probably suffers little from over-confidence.

Experience is also a factor - inexperienced investors are generally more confident of their ability to beat the market than long-time investors.

Keep your ego under control


Shefrin says some investors trade too much because "they are motivated to master their environment and it is unpleasant to believe that one has no control, especially where chance and skill elements coexist".

Successful business people often have trouble investing relatively passively - buying and holding - because they see investing as another business which must be mastered and controlled.

Some of my most successful clients are elderly women who have no aspirations to greatness or ego problems.

Remember the bad times too


Think how confident an investor you would be if you believed you always sold at the top and bought at the bottom.

That's yet another problem behavioural economics says we have. We tend to remember our good decisions and forget the bad ones. Better still, we blame them on our financial adviser.

Diversify


Combine optimism and over-confidence and it is not surprising that many private investors fail to adequately diversify.

They believe that a good understanding of a few shares (their own portfolio) is a better risk-management tool than diversification.

Many traditional local share investors adopt this strategy but mistakenly believe that reading stockbrokers' research and annual reports gives them a degree of foresight.

This is particularly unfortunate as the latest research from the US indicates that, whereas 20 years ago one needed only 20 shares to achieve a high degree of diversification, today the volatility of individual shares means a 50-share portfolio is needed.

Don't stay at home


Many people tend to concentrate their investments in their home sharemarket.

This is not a huge problem if you live in the US, which accounts for over 50 per cent of all world sharemarkets, but can cause all sorts of problems if you live in a small place - like New Zealand.

Shefrin says Europeans buy European stocks, Japanese buy Japanese stocks and so on. Why? Familiarity. Behavioural theory tells us that investors have a natural aversion to ambiguity, so tend to stay at home.

Forget the forecasts


Many share investors are preoccupied with predicting things - either the market's overall direction or the price of particular shares.

Behavioural economics suggests that many people formulate their predictions by naively assuming that the trends they believe they see in graphs are likely to continue.

Investors also underestimate the degree to which their shares move in tandem with the market as a whole.

Don't be afraid of losing


Behavioural economics says we are "loss averse" - a gain gives us less pleasure than the pain we feel from a similar-sized loss.

In investment, this means we tend to sell winners too soon and hold on to losers.

Research suggests that once the loss gets over 30 per cent, selling is out of the question for many people. However, shares which have produced large returns in the recent past are likely to be sold.

Is there a lesson here for long-suffering Brierley or Trans-Tasman shareholders?

Risk is less fun than you think


Researchers reckon most people over-estimate their tolerance for risk.

Knowing that fact has a practical application when it comes to that perennial question: should I invest or pay off the mortgage?

In theory, if the cost of borrowing (after tax) is less than the return on an investment (after tax) then keeping the mortgage and investing is the way to go.

But that strategy ignores the fact that many people overestimate their tolerance for risk. When the inevitable downturn comes, the indebted investor is likely to be less tolerant of losses than the investor with no debt, and is more likely to respond by selling shares, usually at the worst possible time.

Similarly, some strategists, often with little experience of dealing either with real investors or a sustained downturn, look at the superior long-term performance of shares and their tax advantages and simply conclude that "bonds are for losers".

When the sharemarket is going up this theory works perfectly, but add a bit of uncertainty to the job market, stir in a prolonged downturn in the sharemarket and 100 per cent shares no longer seems such a sure bet.

Watch for rules of thumb


Investors make mistakes because they rely on "rules of thumb".

A good example is the one that says, "Past performance is a good predictor of future performance so one should invest in unit trusts with the best five-year record".

While this rule of thumb provides a simple way to pick from the multitude of managed funds, it is usually dead wrong.

Shefrin details several other misleading rules of thumb. One is what is known as "representativeness" - the tendency to rely on stereotypes.

One example is the way in which long-term forecasts made by share analysts tend to be biased towards recent success - they are much more optimistic about shares which have performed well recently than they are about recent poor performers.

* Brent Sheather is a Whakatane investment adviser.