Rational and efficient investment decisions give rise to an ideal state that only seldom materialises in reality. Nevertheless, the theory of homo oeconomicus, who maximises his profit, persists to this day – despite the proven issue of overconfidence, a lack of information and emotional dependencies. The interdisciplinary subject area of behavioural finance investigates these mechanisms and offers financial intermediaries and private individuals interesting solutions for making sustainable investment decisions.
The term homo oeconomicus has already existed for more than 100 years and been used as a fundamental model for financial decisions. The idea behind it is simple: in taking financial decisions, all people behave in a manner that allows them to achieve the greatest possible profit. They also act in a rational manner, i.e. driven by profit and without emotion, and do not allow themselves to be influenced by any information that is not relevant to the decision in question.
As the smallest economic unit, individuals find themselves at the heart of this model. However, its framework can be expanded to incorporate all entities and organisations that are faced with decisions and required to form a preference order for which people are ultimately responsible. The sum of all individual decisions thus constitutes companies at a higher level – from handicraft businesses and car manufacturers to financial intermediaries.
The fact that market participants do not always act rationally was never disputed here. For a long time, however, the belief persisted that less educated people would deviate from this maxim and that therefore no systematic or structural deviations could exist. It was conceded that financial players make behavioural mistakes, but only in individual cases – this irregularity was not considered a mass phenomenon. If this were the case, the assumption of homo oeconomicus as the “average” investor would of course be justified.
For several years, the interdisciplinary research field of behavioural finance, which emerged from behavioural economics, has been investigating events on financial markets with the help of methods and findings from the realms of psychology and sociology. In doing so, it invariably finds that market participants and experts in fact only act rationally to a limited extent due to psychological, mental and neural influences.
A description of seven classic behavioural errors made by individuals in taking investment decisions as well as corresponding solutions can be found below.
1. The disposition effect – why decliners are held for too long
It is often observed among financial players that profits are realised too quickly while loss-making investments are held for too long. Scientific studies are in agreement that inner loss aversion is the main reason for this. This means that the pain felt within the context of a loss is greater than the joy experienced upon making a profit in the same amount. The psychologists and cognition researchers Daniel Kahneman and Amos Tversky illustrated this relationship for the first time in 1979 as part of their prospect theory, for which Kahneman was later recognised with the Nobel Prize.
If you take the grey dot as the starting point, you find yourself in positive territory and are currently 1,000 points up. The joy of 500 additional points is significantly less great than the felt loss upon losing this amount – measured according to the course of the s-curve. When in positive territory, financial players therefore adopt a more risk-averse approach and often sell successful shares too quickly in order to realise their profits.
However, if you initially find yourself on the black dot in negative territory, a gain of 500 points is viewed far more positively relative to the amount of pain caused by the same loss. Consequently, financial players in negative territory are therefore more prepared to take risks. For financial intermediaries such as asset managers, this means, for example, that poorly performing shares tend to be held as the anticipated profit to be gained from a potential price increase is much greater than a further loss.
2. The anchor effect – how input tricks financial players
During negotiations or on markets, an unrealistically high price is often initially demanded, with all involved players knowing that it is excessive – the reason for this is the so-called anchor effect.
The human brain invariably attempts to take decisions in as simple a manner as possible and therefore makes use of easily available information. Heuristics such as an anchor accommodate this process. Investment decisions are thus influenced by values and figures that market participants are faced with during the decision-making process – as it turns out, these do not even have to be directly linked to the decision situation.
In a study conducted by Kahneman and Tversky in 1974, six test subjects were asked to estimate what percentage of the UN is made up by African countries. Before providing their answers, they spun a wheel of fortune. This was rigged and showed either the number 10 or the number 65. When the wheel of fortune stopped at 10, the participants estimated the share of African countries at 25% – if it landed on 65, the average estimate stood at 45%. Although completely irrelevant to the individual’s own estimate, the result of their spin on the wheel of fortune acted as an anchor. With respect to investment decisions, irrelevant anchors thus frequently play a major role and lead to incorrect decisions.
3. The home effect – why investors invest too much in their home market
Financial players tend to invest excessively in domestic financial products and therefore disregard the fundamental concepts of diversification. For example, studies conducted in the 1990s show that 79% of all German shares were also held by German investors. In the US, the corresponding figure at the time was even more than 90%. More recent reliable studies from 2015 reveal that while this effect is no longer as marked as it once was, it remains very strong. Apparently, since the financial crisis in 2007, in particular, investors are increasingly making sure to diversify their investments more broadly from a geographic perspective.
The home effect can be well explained by the fact that investors want to save on transaction costs and also have the feeling that they know a great deal about domestic companies. While lower transaction costs are a fact here, the impact of the feeling of “knowing more” is clearly overestimated. This home bias is very strongly driven by a need for control and overconfidence in one’s own expertise.
However, while a subjective benefit can still be gained with respect to this desired control, the overestimation of one’s own knowledge – whether as an individual or as part of a company decision – is very dangerous.
4. Excessive self-confidence – the feeling of being better than average
The phenomenon of overconfidence rears its head in all areas, as market participants tend to assess their capabilities positively relative to those of others. For example, the Swedish psychologist Ola Svenson demonstrated as far back as 1981 that a total of 40% of car drivers put themselves in the top 20%.
Investors also often overestimate their capabilities in the areas of market trading and securities selection. In 2001, the Professors of Finance Brad Barber and Terrance Odean showed as part of a large study of 35,000 investors that they bought and sold far too often. If they had held their securities for longer and thus put their faith more in the market than their own abilities, they would have been able to generate higher returns: those who did very little trading achieved a return of 18.5% while active traders only succeeded in posting a net return of 11.4%.
There was also a big difference between the two genders: men underperformed the market with their returns by 2.6 percentage points, while women only lagged behind the market by 1.7 percentage points – men traded far more actively as they believed they could better predict the market than others. However, trading also leads to an increase in transaction costs, meaning the average returns were even lower.
5. Hyperbolic discounting – why saving is so difficult
When financial players are given the choice between either wanting to accept a voucher worth CHF 15 immediately or CHF 20 in cash four weeks later, the vast majority opt for the voucher. Viewed from an economic perspective, this makes no sense as the latter option has a greater value. However, immediate possible consumption is a source of happiness.
Many market participants are at the mercy of a strong preference for the present. For example, everybody is aware of the importance of saving and providing for their retirement, but the temptation of not starting something today if it can be left until tomorrow is usually too great. The mathematical term for this phenomenon is hyperbolic discounting. The opportunity costs of not doing something today are greater than those of tomorrow – and much higher than those at some time in the distant future. The problem here is that the same problem is there again tomorrow, meaning that many push back saving for their retirement by years or decades. The problem is currently exacerbated by the low-interest environment in which saving already offers little in terms of attractiveness.
An experimental study into old-age retirement planning by the American behavioural economists Richard Thaler and Shlomo Benartzi from 2004 shows how this psychological repression can be countered on the basis of a simple idea. Employees of a company were offered to conclude a savings plan today for which the first payment would only fall due in the following year and even then only if they received a salary increase. Due to the changed deposit times, saving rates rose from under 5% to more than 9%. The temptation to consume money immediately was counteracted by the positive impact of the salary increase and the automatic savings plan. The idea was so successful that it is now offered at many US firms.
6. Overreaction to media representation
There are currently around 35,000 public limited companies worldwide – 7,000 of which are based in the US alone. Investors are overwhelmed by this choice, which they therefore often simplify by only taking those companies into account that they already know. Focus with respect to securities is therefore automatically placed on those companies with a considerable media presence or which provide particularly striking information as this is easier to access.
For example, private investors often invest in shares that attract attention due to reporting in the media or especially high-volume trading. This can mean, however, that these shares increase in price due to the unnaturally high level of demand and can thus no longer provide the expected returns, as shown by a scientific study conducted in 1985 by Richard Thaler and Werner De Bondt, one of the founders of behavioural economics. There are also studies that demonstrate that private investors respond strongly to certain signals such as earnings announcements – here, investors are easily led to mistakenly believe they are well informed or are “striking while the iron is hot”.
7. Mental accounts – creating deceptive systems in our brain
It can often be observed that people tend to be more willing to pay high default interest on their current account than to withdraw money from their savings account in order to settle their overdraft. From a financial perspective, this of course makes no sense. The reason for this behaviour are so-called mental accounts: people – like investors – store their assets in different mental pigeonholes and treat these completely separately. If investors have invested in various projects – shares, savings plans or funds – they do not have all of their assets with their respective risks and returns in mind as a whole, but rather maintain a separate mental account for each one. The effect also supports the disposition effect described above, as investors like to divide their assets into “winners” and “losers”.
Even small changes in the naming or organisation of accounts can give rise to a change in the way in which the funds they hold are treated. When handling individual sub-areas and finding appropriate solutions, there is always the risk that this may lead to a suboptimal solution overall. In their role as financial intermediaries, personal advisors should therefore place an emphasis on the assets in their entirety in order to offer an optimal solution.
Implications for financial intermediaries
Intermediaries and professional market participants alike are faced with the question of how such inappropriate behaviour can be best handled. After all, in situations in which relevant decisions have to be taken by human individuals, it is always difficult to avoid the mistakes described above, as the outlined mechanisms are anchored deep in the human psyche and occur at a subliminal level.
In decision-making situations, however, research shows that even following just a few principles and applying the food for thought provided above allow for many of the aforementioned errors to be avoided or reduced. These play a key role, in particular for intermediaries such as asset managers, who are doubly exposed to the risks of behavioural distortions. On the one hand, they often make decisions on behalf of their clients by proxy and have to make sure that they do not make investment errors themselves. On the other hand, they also need to ensure positive expectations management in their communication with clients as well as offer good products and solutions that minimise distorted behaviour.
The best approach to this end is the conscious activation of the reflective thought system. Most behavioural errors occur when decisions are based on an individual’s gut feeling rather than on deliberate contemplation. The latter requires a great deal of energy and resources. The human brain therefore attempts to avoid these complex processes in order to make decisions quickly and efficiently. Intermediaries do not do themselves any favours by taking or accepting quick decisions. Instead, they should rather try to take very conscious decisions and also communicate the key reasons for them accordingly.
Good asset managers have the courage to also take difficult and unusual decisions. As shown above, there is, for example, often too little geographic diversification – usually due to felt uncertainty, which prevents a decision in favour of a more efficient investment. It can often suffice to consider more transparent products such as global index funds for diversification purposes and to emphasise the benefits during the portfolio discussion. The courage should also be found to keep hold of gainers and sell decliners.
It is likewise of key importance to offer and use financial instruments for self-control purposes within the portfolio. In addition to binding savings plans, one investment type could also be the conscious taking out of a loan for the purchase of real estate. This requires regular repayments, i.e. regular capital utilisation, and appears especially attractive in the current low-interest phase.
Finally, it is important that reasons viewed as key to the decision-making process are recorded in order to allow for it to be assessed ex post. If this happens in the case of both positive and negative developments, it becomes easier to also accept and process negative developments as a natural part of investing. The understanding that this promotes helps in being once again able to act objectively and rationally in taking subsequent decisions.