For many years academics studying stock markets have been trying to persuade investors that markets are efficient.
Efficient Market Hypothesis suggests that you cannot beat the market over time. Information is widely available and any positives or negatives regarding a stock will already be built-in to the price.
This theory has certain attractions. It suggests all stock market analysis and investment decisions can be reduced to mathematical formulae and it fits in with the belief in the all-powerful efficiency of free markets.
However, it doesn’t take a genius to see that there are serious flaws in this concept.
Fund managers such as Warren Buffett and Neil Woodford have made vast amounts of money for investors by taking “contrarian” positions in stocks they feel are undervalued. Markets may be efficient in pricing stocks, but the price includes the value of the underlying company and a psychological element driven by emotions.
Emotions play a significant role in investment decisions.
From the South Sea Bubble to dot-coms, investors have been unable to separate themselves from their emotions. A recent study even suggested a strong link between weather and daily stock market fluctuations. A sunny day was more likely to see a rise in values.
These observations have led to a field of study called Behavioural Finance which seeks to understand how and why people invest.
Investors are generally risk-averse. People tend to feel much worse about investment losses than they feel good about equivalent gains. They hold large sums in bank accounts on the basis that they are safe, at the expense of achieving possibly much higher gains from stocks and shares.
The investor is attempting to avoid the “buyer’s remorse” of making an investment that loses money. But this same emotion can lead to the retention of investments that have gone seriously wrong because to sell would be an admission of a mistake and a blow to one’s pride. Studies suggest that pride and regret cause us to sell good investments and hold on to bad ones.
Of course the reason we bought a fund in the first place may be herd mentality. If everyone else is investing, it can’t be a bad investment. But when they go with the flow, investors do not take the time to adequately research a particular investment. Therefore, they are not making an informed decision. People do not want to regret making a bad decision, but herd mentality allows them the comfort of knowing they aren’t alone in their decision.
Over-confidence is another trait which some investors suffer from. We believe we have more knowledge and more control than we actually do. And over-confidence can also lead us to hold poorly performing funds for longer because we believe we understand why and when things are going to improve. We also tend to accept information that supports our view of an investment and ignore anything that contradicts that view.
People often equate investing with their first investing experience, the “first impressions” approach. If they choose a winning investment the first time they invest, they perceive investing as less risky. Investors tend to use past investment outcomes to evaluate a current situation. As they say: “Past performance is not a guide to the future.”
Virtually all investors have some of these tendencies to a greater or lesser extent, even fund managers. The key is to try to get beyond these urges to see the true nature of an investment.
Understanding your investment personality is vital. Acting without emotion is extremely difficult when making investment decisions. Therefore, it is helpful to recognize one’s emotions and take them into account.