Written by Damen Kloeckner, Associate Analyst
More and more, the old axioms of rational, efficient economic markets have given way to admissions of irrational behaviour pervasive in world markets. Short term price momentums are common, bouts of extreme volatility have become more frequent and a herd mentality has insidiously taken hold of the investing psyche. As value investors, we find ourselves in a bipolar market oscillating between extremes of fear and greed which can make stock picking seem frustrating or even futile.
In many ways however, value investing relies on such irrationality. If markets were 100% efficient, there would be no material price departures from fundamental value and it would be impossible to beat the market through active investment (stock picking). Applying these tenets requires patience and conviction and can often test the will of investors. However, identifying this irrationality as it manifests as observable behavioural biases can ease this burden. As an analyst I have learned that biases exist at all levels of investment expertise, from individuals, to investment managers, financial advisers, brokers and all other market participants, exacerbated by self-interest and complacency. Learning to identify and avoid biases in one’s own investment decisions and to exploit the biases of others can support and augment an intrinsic value philosophy.
Some of the most widespread biases I have witnessed as an analyst are anchoring, overconfidence, confirmation bias, loss aversion bias and herding. They are explained below with examples for illustration.
Loss aversion bias
One of the defining biases that dominates investment decisions is loss aversion, which refers to investors’ tendency to prefer avoiding losses to realising gains. Losing $1,000 is felt much more strongly than gaining $1,000. Fear is more powerful than greed. This is why bear markets often appear much more suddenly than bull markets, and are much sharper in their reactions. Markets ‘take the stairs up and the elevator down’ as the saying goes. In this way, it can be observed that loss aversion creates a bias to negativity in markets where reactions to bad news are often much stronger than reactions to good news. As analysts, we observe this frequently, with downgrades often causing much sharper reactions than upgrades.
On an individual level, loss aversion also causes portfolio mismanagement. If you’ve ever held a stock which has performed particularly poorly (and most of us have), you may have found yourself unable to sell it even as it dropped further and further. Realising the loss (by selling the shares) is very painful, and also requires an admission of fault, which as we have talked about, violates investors’ confirmation bias. It is much easier to hold the stock in the hopes that it eventually performs, creating massive opportunity costs and in many cases, further destroying wealth.
Take the prolonged poor performance in the Australian mining sector for example. The mining index has halved over the last five years (accounting for dividends). Countless research has been published throughout this period urging investors to sell down (or out of) mining stocks; yet investors have clung desperately to these underperforming positions. To this day, we still receive portfolios for assessment from investors with double digit positions in BHP or Rio Tinto. The notion that such stocks will ‘come good’ eventually has caused a great deal of wealth destruction through inaction or obstinacy. The fact that these losses are unrealised is irrelevant and creates a dangerous fallacy.
Figure 1. Cumulative total return on ASX 300 Metals and Mining Index, 2011-2016
Source: Thomson Reuters Datastream
Anchoring refers to the tendency of investors to attach their views to irrelevant, out-dated or incomplete information in making decisions.
Anchoring is so widespread and impactful in the market that it has come to define an entire style of investing. Relative value investing prices industries and sectors based on valuation multiples which are made to fit a host of different stocks, each with unique risks and opportunities. At some point, if one stock is used to value another and so on, the logic becomes circular and is difficult to even discern what the original anchor was. Even within intrinsic valuation, estimates are often anchored to longstanding assumptions that may no longer be or have never been appropriate. For example, assumptions regarding the risk free rate and the sustainable GDP growth rate are integral in such models and are expected to remain constant perpetually, thereby acting as anchors.
Avoiding anchoring is a matter of discipline. Investors must assess the validity, relevance and completeness of the information that led to their investment decision. If a company exhibits predictable and defensive earnings growth, applying a historical rate may be appropriate. If it has consistently grown at x% above industry rates, that may too be an appropriate benchmark. The point is to know the assumptions behind any estimate or valuation and assess their appropriateness.
Overconfidence and confirmation bias
It is a basic human quality to overestimate our own abilities. If we didn’t feel ‘above average’ in our stock picking abilities, by definition we would be better off investing passively. This overconfidence is amplified by a hindsight bias, which causes us to exaggerate our predictive capabilities based on the perceived obviousness of the past. In reality, this is a fallacy – as the past is often not a reliable indicator of the future. Misplaced confidence feeds into a phenomenon known as confirmation bias, which explains investors’ tendency to selectively seek out information which supports our existing views and to ignore or dispute information that does not. This can lead to poor investment decisions which do not make use of all available information. In fact, investors have been shown to ignore even basic logic in instances where it would conflict with a pre-existing view.
This is especially true for existing stocks in an investors’ portfolio which they are said to endow with additional, imagined value, further enhancing the confirmation bias. When holding a stock, whether it has outperformed, underperformed or performed to expectation, investors often see residual upside, and will vehemently hunt information that justifies their view. This results in a cognitive inertia whereby securities are held merely because buying or selling would require revision of existing views.
Avoiding overconfidence is difficult, but it can be managed through objective reasoning and fundamental analysis. Allowing your analysis to form your opinion and not the other way around is important. Investors should also periodically reassess their original thesis and attempt to form counterarguments against it. By evaluating the merits of both the investment thesis and its counterargument regularly, more informed and objective decisions can be made. One strategy to limit the scope for overconfidence is to use stop loss orders, which automatically sells shares should a predetermined price level be breached. If you buy a stock for $10 per share, and can tolerate a maximum loss of 15%, you may set a stop loss order at $8.50, for example.
In investing as with life, people are predisposed to a herd mentality. We have a tendency to make decisions based on the actions of a larger group, in some cases even overruling our existing individual views. The social pressure to conformity is immense in investing at all levels. Particularly for professional investors, who control the majority of major investment decisions in the market, getting something wrong when everyone else does is much easier than having a contrarian view that proves equally incorrect. Again, this may sound obvious but do not underestimate the influence of the herd bias on market movements. It is why, contrary to common sense, most investors buy shares when the market is going up and sell when it is going down as they collectively oscillate between fear and greed. This creates momentum within the market itself and at an individual security level. Investors cluster around a group of good ideas, buying outperforming securities and driving prices up in the process.
This periodically culminates in catastrophic asset bubbles, the zenith of the herd mentality. In such cases, there are often discernible indicators that prices are unsustainably high and that a correction is imminent but the herd pushes on. When the bubble inevitably pops, the resulting price falls are as devastating as they are abrupt, falling to levels often well below intrinsic value, as the herd’s collective panic overrules individual logic.
Even knowing the devastating effects of this bias, it can be extremely difficult to avoid. Having the conviction to buy in bear markets as prices continue to fall seems ludicrous at the time but it is a central tenet of value investing and one of the guiding principles of investors such as Warren Buffett. It is vital to maintain a view on intrinsic value for all equity investments and to invest or trade around those values. If you have conviction in your views and can identify when market sentiment materially departs from fundamental expectations, this herd mentality can not only be avoided, but exploited.
The chart below illustrates the herd mentality behind the formation of asset bubbles. Looking at two examples, the first from the ASX All Ords from 2003-2010 and the second from the Chinese market in 2014-2015, the effects of herding can be devastating to wealth creation (and protection).
Figure 2. Jean-Paul Rodrigue’s ‘Stages of a Bubble’ chart
Source: Bloomberg View
Figure 3. ASX All Ordinaries Price Index, 2004-2010
Source: Thomson Reuters Datastream
Figure 4. Shanghai SE A Share Price Index, 2014-2015
Source: Thomson Reuters Datastream
Every investor has a desired risk/return profile and attempts to invest accordingly. The difference in views and objectives is what makes a market and there can be more than one rational view for any given decision. Within this decision making process however, behavioural biases exist which not only hinder investors’ ability to achieve their own goals, but aggregate in the market to form observable phenomena such as momentum, bubbles and excessive volatility.
Being aware of these inherent biases, and removing as much emotion, subjectivity and complacency from your decision making, is vital in today’s market. Not only does it support your own investment process but allows you to exploit the same irrationality within the shared market psyche.