Curb irrational behaviour
The strategy To avoid common mind traps when investing.
You're talking about fear and greed, right? There's no doubt fear and greed are behind a lot of investor behaviour - much of it is irrational. But a school of study, known as "behavioural finance", has demonstrated our minds are hard-wired to react in certain ways. Even if we make concerted efforts to avoid fear and greed, our thought patterns may lead us to make investment decisions that could prove costly.
Such as? There are many aspects to behavioural finance but one area Tyndall Investment Management's Australian equities team believes may be influencing investor behaviour at the moment is "anchoring". In simple terms, this is the tendency we have to base our judgment on a piece of initial information then stick with it even if other information becomes available.
To show how it works, Tyndall looked at research by two behavioural finance experts, Amos Tversky and Daniel Kahneman. They asked two groups of people what percentage of the United Nations comprised African countries.
In the absence of real information, the test groups tended to "anchor" their estimates on any information available rather than thinking independently.
In another study, psychologist Ward Edwards asked people to imagine 100 bags of poker chips. Each bag contained 1000 chips but 45 contained 700 black chips and 300 red while 55 contained 300 black and 700 red.
But he then asked them to imagine 12 chips were randomly selected from the bag - eight black and four red. The chips were put back and the respondents were asked whether they would change their first answer in response to the new information.
You're talking about fear and greed, right? There's no doubt fear and greed are behind a lot of investor behaviour - much of it is irrational. But a school of study, known as "behavioural finance", has demonstrated our minds are hard-wired to react in certain ways. Even if we make concerted efforts to avoid fear and greed, our thought patterns may lead us to make investment decisions that could prove costly.
Such as? There are many aspects to behavioural finance but one area Tyndall Investment Management's Australian equities team believes may be influencing investor behaviour at the moment is "anchoring". In simple terms, this is the tendency we have to base our judgment on a piece of initial information then stick with it even if other information becomes available.
To show how it works, Tyndall looked at research by two behavioural finance experts, Amos Tversky and Daniel Kahneman. They asked two groups of people what percentage of the United Nations comprised African countries.
- The first group was asked whether it was above or below 10 per cent;
- the second whether it was above or below 65 per cent.
- The first group, having a lower "random" figure estimated an average 25 per cent of African countries;
- the second 45 per cent.
In the absence of real information, the test groups tended to "anchor" their estimates on any information available rather than thinking independently.
In another study, psychologist Ward Edwards asked people to imagine 100 bags of poker chips. Each bag contained 1000 chips but 45 contained 700 black chips and 300 red while 55 contained 300 black and 700 red.
- When asked what the probability was of selecting a bag with mostly black chips, most of the test subjects got it right.
- The answer was 45 per cent.
But he then asked them to imagine 12 chips were randomly selected from the bag - eight black and four red. The chips were put back and the respondents were asked whether they would change their first answer in response to the new information.
- Many said the probability of the bag containing mostly black chips was unchanged at 45 per cent.
- Most said the likelihood was less than 75 per cent.
- But calculated mathematically, the bag was 96.04 per cent likely to contain mostly black chips.
- The respondents didn't take account of the new information.
But how does that relate to my reactions to investment markets? Tyndall says the same research has been conducted on analysts' reactions to company earnings announcements.
It says basing future investment performance on past returns is another common example of anchoring.
So how do I avoid this trap?
Old favourites, such as having a diversified portfolio, getting good professional help and looking to the long term can help.
http://www.smh.com.au/news/business/money/investment/curb-irrational-behaviour/2010/04/06/1270374188426.html?page=fullpage#contentSwap1
- They often don't revise their estimates enough when they receive new information, resulting in a string of earnings "surprises".
- It says the recent rally has resulted in largely favourable earnings forecasts but if the numbers don't live up to expectations and investors haven't factored in changing circumstances to their thinking, the market could fall sharply.
It says basing future investment performance on past returns is another common example of anchoring.
- After shares fell more than 38 per cent in 2008, most investors expected a dud 2009.
- Certainly no one was predicting a rise of 37 per cent. Investors who switched money out of shares paid dearly.
So how do I avoid this trap?
- Understanding these behaviours and being aware of them can help you make more informed and rational decisions.
- Even better, Tyndall says, it can give you an edge, allowing you to identify, and make money from, mispricing opportunities that come about because of other people's irrational behaviour.
Old favourites, such as having a diversified portfolio, getting good professional help and looking to the long term can help.
http://www.smh.com.au/news/business/money/investment/curb-irrational-behaviour/2010/04/06/1270374188426.html?page=fullpage#contentSwap1
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