Active managers can cash in on human nature

By

17/04/2017

If you had a choice between an 80 per cent chance of winning $4000 and a 100 per cent chance of winning $3000, what would you do? And if you had an 80 per cent chance of losing $4000 or a 100 per cent chance of losing $3000, which would you choose?

If you chose the second option in the first question and the first option in the second, you’re not alone; most people do. Offered the certainty of winning a lower amount of money, we’d typically take it, rather going for the bigger amount and accepting the 20 per cent risk of not winning.

But we’d just as typically gamble and accept the 20 per cent chance of not losing $4000 in preference to the certainty of losing $3000, even though the cost of accepting those odds is theoretically higher –$3200, or 80 per cent of $4000 – than accepting the straight loss of $3000.

This, as any student of economic or financial behaviour will tell you, is a classic instance of where the theories of rational economic choice and efficient markets break down. When making financial decisions, we’re governed more by emotions than by calculations of probability.

Insights such as this have become increasingly common since psychologist Daniel Kahneman and others began applying their techniques to the fields of economics and investment. Their significance was underlined in 2002 when Kahneman won the Nobel prize in economics.

So what can behavioural insights teach us about investment and can they make us better investors?

Common biases

In addition to the lesson of the choice paradox above – that we feel the pain of losses more than the pleasure of gains – there are four other behavioural insights that can be particularly useful for investors:

  • We tend to anchor ourselves in recent observations, such as this morning’s financial headlines. This can undermine the impartiality and independence of our decision-making.
  • We overestimate our skills. The joke about 90 per cent of drivers believing they are better than average is based on research. A related cognitive bias persuades us we can win the lottery against massive odds.
  • The ownership effect, which makes us value something more if we own it than we would if we didn’t. This can make us reluctant, for example, to part with possessions that have outlived their usefulness.
  • A tendency to see patterns where none exist (for example, the shapes of animals and other objects in cloud formations) is another bias that can make us over-confident when making decisions.

How are these biases relevant to investment?

Turning biases to our advantage

Insights into human nature and behaviour have, in fact, been important elements in actively managed investment styles since long before behavioural finance became a distinct field of study.

The value investor, for example, looks for shares that have become over-sold. Very often, the buying opportunity will be all the more attractive because loss aversion makes other investors fearful of companies facing short-term difficulties, and their views of such companies are anchored in recent performance, making then unwilling or unable to see any potential for recovery.

Sell-side analysts can be good prey for growth or quality investors; they usually have little incentive to differ too much from one another in calling the direction of a share price, and tend to follow one another in issuing upgrades or downgrades incrementally.

This can cause them to anchor themselves in recent perceptions, creating an opportunity for shrewd investors to position themselves ahead of the pack and benefit when sentiment changes.

Lastly, low-volatility strategies capitalise on the tendency of humans to overrate their stock-picking abilities by, for example, buying a sexy or superficially attractive stock that is also volatile (technology IPOs can be good examples).

The widespread nature of this bias attracts many investors to the stock, which consequently becomes overbought and overpriced, leaving the lower-volatility stocks (which tend to outperform markets on a risk-adjusted basis) to less impulsive investors.

Clearly, these insights work best for investment strategies that are actively managed. That’s because active investment management can best exploit these fundamental aspects of human nature, turning irrational behaviour in markets – of which we are seeing a great deal at the moment – into an opportunity rather than a risk.

This article is based on a presentation made to Investment Management Consultants Association (IMCA) seminars in Sydney and Melbourne during February and March 2017. Stuart Rae is chief investment officer, Asia-Pacific ex-Japan Value Equities, at AB.



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