Behavioural biases: unravelling our irrational investment habits

Amid market volatility, currency fluctuations and a climate of uncertainty surrounding South Africa’s growth prospects, it becomes increasingly important to explore the common biases that can significantly impact financial decision-making.

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_Nicole_Loker

Biases, inherent to human psychology, often influence our judgements and actions in ways that may not align with rational economic principles. These biases become particularly relevant as we navigate the challenges posed by the current landscape. From Eskom’s persistent power supply issues to concerns over corruption and political uncertainty, these factors have contributed to a loss of faith in the system by many investors. By understanding and addressing these biases, individuals can strive to make more informed financial choices, mitigate risks and potentially navigate turbulent market conditions with greater resilience.

In this article, we look at five of the most common behavioural biases that influence an investor’s decision-making.

1. Confirmation bias

Let’s start with one of the most common biases in finance – confirmation bias. This bias leads us to seek information that confirms our existing beliefs and ignore evidence that challenges them. An investor might have a strong belief that a particular industry or company is poised for success, leading them to selectively consider news and reports that support this belief. Unfortunately, this bias can hinder objective decision-making and prevent investors from considering alternative perspectives.

Buy when the blood is running in the streets

One example of a well-known share that has experienced confirmation bias in the past is Steinhoff International Holdings N.V. (Steinhoff), a multinational retail holding company based in South Africa.

Before the revelations of accounting irregularities in late 2017, Steinhoff was considered one of South Africa’s most successful and promising companies. It had a track record of rapid expansion, acquiring various retail chains globally and gaining the trust of many investors.

Confirmation bias became evident as many investors and analysts held a positive view of Steinhoff’s financial performance and growth potential by focusing on all the good news. They focused on the company’s consistent revenue growth, its high-profile acquisitions and the apparent strength of its balance sheet which led to continued buying and an increase in its share price.

However, when the accounting irregularities were exposed, it was revealed that Steinhoff had manipulated its financial statements, leading to a significant loss in market value and a collapse in investor confidence. This revelation highlighted how confirmation bias had influenced investors’ perceptions of the company.

Despite analysts pointing out warning signs and red flags, such as complex and opaque financial structures, and even being laughed out of court, some investors chose to ignore or downplay these indicators that contradicted their optimistic viewpoint. They selectively interpreted positive news and disregarded or undervalued information that highlighted potential risks or inconsistencies in Steinhoff’s financial reporting.

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Chart 1: Steinhoff Historical Share Price

The example of Steinhoff demonstrates how confirmation bias can cloud judgement and lead investors to overlook critical information that contradicts their preconceived notions. It serves as a cautionary tale about the importance of conducting thorough due diligence and considering diverse perspectives when making investment decisions.

2. Anchoring bias

Anchoring bias refers to the tendency to rely heavily on the first piece of information encountered when making subsequent judgements or decisions which can influence the valuation of assets. For instance, if an investor perceives a particular stock’s fair value to be at a certain level, they might anchor their expectations to that value, even in the face of new information that suggests a different valuation. A good example of anchoring bias is house prices.

A closer to “home” look at behavioural anchoring bias and the influence of house price anchors. 

When individuals are in the process of buying or selling a house, they often encounter an anchor, such as the initial asking price, the listed price or the most recent sale price of a similar property. This anchor serves as a reference point that influences their perception of the property’s value.

Assimilation Effect. 

In this case, individuals tend to adjust their perception of a house’s value closer to the anchor. For example, if a house is listed at a high price, potential buyers might consider it to be a premium property, even if it lacks certain desirable features or is overpriced compared to similar properties in the area. This assimilation effect can lead to buyers overestimating the value of a property and making offers that are closer to the anchor price.

Contrast Effect. 

On the other hand, the contrast effect occurs when individuals adjust their perception of a house’s value away from the anchor. If a house is listed at a significantly lower price than similar properties in the area, potential buyers might perceive it as a bargain or a distressed sale. This contrast effect can lead to buyers underestimating the value of a property and potentially making lower offers than they would for similar houses with higher anchor prices.

The anchoring bias in the housing market is further exacerbated by factors such as limited market transparency, subjective valuation methods and emotional attachments to properties. These factors can reinforce the influence of the initial anchor and make it more challenging for buyers and sellers to objectively evaluate the true value of a house.

Another well-known example was during the launch of the iPad when Steve Jobs defied the experts’ prediction of a $999 price tag and surprised everyone with an actual price of $499, causing people to be amazed by its fairness due to the phenomenon of placing greater emphasis on the initial information encountered.

In the investment world, a common scenario arises when investors accumulate an overweight position in shares because of their current or past employment, typically through a company’s share incentive scheme. However, over time, there may be a growing need to diversify these shares. Unfortunately, investors often fall into the trap of anchoring their expectations of future share prices solely based on previous highs or historical performance. They maintain the assumption that the shares will eventually reach or surpass those previous levels, disregarding changing market conditions or other factors that can impact the share price.

Consequently, they tend to only consider selling when the shares breach or approach this specific threshold. This situation raises a critical question about whether potential alternative opportunities have been overlooked, irrespective of whether the share price may eventually rebound to its all-time highs.

3. Herding behaviour

Humans are social creatures, and this is evident in financial markets through herding behaviour. This bias describes the tendency to follow the crowd and make investment decisions based on what others are doing and is often seen during periods of market euphoria or panic. When everyone is investing in a particular asset or sector, individuals may feel pressured to join in, often overlooking careful analysis of the investment’s fundamentals.

Research showed that there is an 80% correlation ratio between Bitcoin prices and Internet searches for the asset. (The table below shows a snapshot of Bitcoin price vs Google searches for Bitcoin over a two-year period.)

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Chart 2: Prices for Bitcoin vs online searches for the asset

On the home front amidst negative press triggering a collective exit of investors from South African-incorporated (SA Inc) stocks, herding bias emerges as investors follow the crowd. However, caution is warranted as this bias might lead to missed opportunities. Certain companies offering exceptional value and significant upside potential could be overlooked. By blindly succumbing to herding bias, investors risk missing out on undervalued opportunities that could yield favourable returns and significant upside. A discerning approach, grounded in thorough research and analysis, is essential to identify attractive investments with strong fundamentals and promising growth prospects.

By capitalising on mispricing caused by herding behaviour, investors have the potential to take advantage of this by buying assets with depressed prices. Baron Rothschild, a prominent financial figure, once famously remarked, “Buy when the blood is running in the streets.” By invoking the imagery of chaos and distress, Rothschild underscores the contrarian nature of successful investors who possess the courage and insight to act when others are fearful.

4. Recency bias

This bias occurs when we rely on recently available information when making decisions, rather than considering the entire range of relevant data. For example, if a particular asset class has been performing well recently and receives extensive media coverage, investors may allocate an undue amount of their portfolio to that asset, neglecting the diversification principle.

Table 2: Demonstrates how last year’s asset class winners are not in the top quartile the following year

Similarly, investors often follow top-performing funds by electing to switch in after a much-publicised run of strong performance relative to peers, frequently selling low and buying high as a result. Recency bias is often heightened at points of volatility and when investors are anxious. An example on the home front could be investors looking to externalise their investments at any cost in the aftermath of the US accusation that Russia received arms in South Africa, with the Rand crashing to a new record low of R19.83/$.

5. Home bias

Home bias refers to the tendency of investors to exhibit a preference for investing in their home country’s assets, leading to an overallocation of investments domestically compared to offshore. In the context of South Africa, we frequently observe opposite home bias where investors show a preference for investing offshore due to recent strong offshore returns and negative sentiment towards our home country.

Between January 1995 and October 2007, a notable divergence occurred between the developed and emerging markets. In the first phase, from January 1995 to March 2000, the developed world witnessed a growth-driven bull market known as the dot.com bubble, fuelled by a surge in investments in Internet and technology stocks. However, the hype surrounding start-ups reached its peak in March 2000, leading to a subsequent decline in the S&P 500, which fell by 49% from March 2000 to October 2002, and which for most of the 2000s remained negative for investors.

However, at the same time, domestic investors benefitted from an unexpected windfall from 2003, earning bumper returns over the next four or five years as the following chart shows. Given the dire economic recession, high interest rates and political risk in our country at the time, many investors did not benefit from this surge to the extent they could have and it would have taken a courageous investor to be fully invested in South Africa over this period.

The question that lingers is: what lies ahead for South Africa? Will the current negative trend persist or are we on the verge of a resurgence reminiscent of the period between 2002 and 2007?

Changing your thinking

To foster more rational thinking and overcome behavioural biases, several techniques can be employed:

Decision-making frameworks. 

Implementing structured decision-making frameworks, such as setting investment criteria, defining risk tolerance and adhering to a disciplined approach, can help reduce the influence of emotions and biases.

Education and awareness. 

Understanding the various behavioural biases that affect investment decisions is the first step towards mitigating their impact. Educating oneself about cognitive biases helps develop self-awareness and enables investors to recognise their own biases in real-time.

Chart 3: JSE ALSI (in ZAR) vs S&P 500 (in USD) over period January 1995 to October 2007

Seeking diverse perspectives. 

Actively seeking out diverse viewpoints and opinions, engaging in constructive debates and considering alternative scenarios can help challenge one’s own biases and promote more well-rounded investment decisions.

Regular self-reflection. 

Engaging in regular self-reflection allows investors to critically evaluate their past decisions, identify patterns of bias and make necessary adjustments to their investment approach.

Professional guidance. 

Collaborating with financial advisors or professionals who are trained to navigate behavioural biases can provide valuable insights, accountability and a more objective perspective on investment decisions.

Conclusion

Behavioural biases present significant challenges for investors and individuals seeking to make prudent financial decisions. The flow of money moving offshore appears to be partially influenced by a combination of these biases. However, by recognising and understanding these biases, particularly during times of heightened volatility or extreme market conditions, we can make well-informed investment choices that consider both the challenges and opportunities, locally and globally.