Warren Buffett reckons to be a good investor “All you need is emotional control and the temperament to avoid self-destructive behaviour”. If that is so, why is it so difficult for the average investor? The problem is we are intuitively “wired” to be lousy investors.
Behavioural finance studies have identified some emotional bias errors, which may explain our shortcomings.
Recency refers to the influence of recent data on our decision making. We look back over the recent past and project / expect more of the same for the future. “Markets have gone up over the last 5 years so they will keep going up”. Our decisions are mostly influenced by available data on-hand, which is heavily weighted to current or recent information flow.
We have very short-term memories and we fail to learn from the past, forgetting very quickly that we may have faced a similar cycle before. We tend to let “this time is different” thinking over-ride rational thought, which usually results in a poor decision. We do not learn from our past experiences.
Investors feel the pain of loss twice as much as they feel the pleasure of gains. We are also twice as sensitive to negative stimuli as to positive. Unfortunately, the newspapers know this, which is why the headlines are always negative; bad news sells!
Loss aversion leads to inappropriate risk budgets, which fail to provide for the investors long-term income and growth objectives. Experienced investors will sometimes mistakenly hang-on to losing investments while selling their winners not wanting to realise the loss.
Successful businessmen are often prone to this bias influenced by their success in business. They are confident by nature, use to be being in control and comfortable taking high risk decisions, usually seeing the “glass half-full”. Novice traders can also be prone to over-confidence mistaking luck with good decision making.
My favourite quote in this regard is from Charlie Munger, who is Warren Buffett’s partner, “the dawning of wisdom is when you realise you know nothing”.
After 24 years in the investment / advice business I am more convinced than ever that the behavioural finance is the most important driver of long-term returns and investors either achieving or not achieving their objectives.
I will close with another quote from the most successful investor of all-time, Mr. Warren Buffet who said” If you don’t know yourself the stock market is a very expensive place to find out about yourself”.
I honestly believe everyone needs a trustworthy adviser to help control their emotional biases. Even advisers need an adviser when it comes to their own finances. But then again Mr. Buffett also said; “Don’t ask a barber if you need a haircut”.
Mcomm, CFP®, HdipTax
T. 021-851 3746