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Behavioural finance: The biggest mistakes investors continue to make

In the second part of a series on behavioural finance, Hans-Jörg Naumer, global head of capital markets and thematic research at Allianz Global Investors, explores how better understanding behaviour patterns can support your advice.

Hans Joerg Naumer

The theory of behavioural finance has derived typical behavioural patterns from the realisation that investors are humans, not robots. An investor who knows these patterns is a step ahead not only with self-awareness, but is also already on the way to outsmarting themselves.

Here you’ll find an overview of the most important so called “anomalies”: behavioural patterns, which are not rational and which the majority of your clients display in one way or another.

Hubris: The most common mistakes resulting from hubris are over-optimism and overconfidence. Both are accompanied by an illusion of control and an illusion of knowledge, meaning it is assumed one is able to control a development that is not controllable, or that one possesses sufficient knowledge for decision making – which is not the case. In the long run it can even involve random developments which are neither controllable nor predictable but whose result the investor attributes to his or her own knowledge.

But this is disastrous: as the illusion of control increases, the willingness to absorb new information and evaluate one’s opinion falls. A spiral quickly evolves after initial investment successes, according to the pattern of “pleasure – greed – euphoria – fear”.

Advisers should also bear in mind that their clients can also be fooled by their powers of recollection. As a general rule, losses are easily forgotten while profits remain stuck in one’s mind. This is also a consequence of overestimating one’s own abilities.

The yearning for (self) affirmation is also dangerous. In this context, only the information that corresponds to the existing assessment is taken into account. Conflicting information is suppressed or is considered less important.

Hindsight bias: With the benefit of hindsight, everything appears to be “crystal clear”: the development of market indicators and equity prices – anyone who knows the charts thinks: “How could it possibly have been any different? I knew that.” Even the stock market crash that began in 2000 seems today to be predictable and virtually logical. But who could have accurately predicted it before the bubble burst? The danger here lies primarily in overestimating one’s own abilities: anyone who believes they were able to foresee a lot in the past will also mistakenly presume this in the future.

Framing: Investors often allow their vision to become restricted by inadequate information. The window, or rather the frame through which they view the investment world, is simply not large enough to be able to review all the pertinent information and at the same time identify investment alternatives or contradictory facts. Investments are frequently made based on the short story, without analysing how long it will last or whether there are other, better prospects.

The frequently observed “home bias” is another classic case of framing and worthy for advisers to bear in mind: investors stick to what they know best. Eg. Italians buy Italian equities – and are poorly diversified.

Anchoring:Investors are also inclined to combine their assessment with – completely irrelevant – “anchors” in their memory. A typical anchor is the price one paid to purchase an equity. In actual fact, the price should be calculated time and time again on the basis of profit estimates, using a Dividend Discount Model valuation method, for example.

Availability bias: How many of your clients kept their resolutions which they have discussed with you at the very beginning of the investment process?

Typically, investors fail their resolutions rather quickly because the realisation of the advantage expected from it lies in the future and the future is uncertain, and because we prefer quick and secure profit, current convenience or immediate advantages.

So why go jogging, give up desserts or stop smoking now, if the expected fruits of this endeavour for one’s own health and a longer life are in the future? Enjoyment will come before the better life of tomorrow. This is a bit like a hunter who immediately consumes his prey because he does not know whether he will be alive tomorrow or not.

The preference for benefits today means by implication that the benefit expected tomorrow is discounted in value. That is quite clever, but clearly the discount factor is so high that the benefits expected tomorrow no longer bear any significance. Recipe for disaster: this is why securing the future is willingly put off until tomorrow too, even though the compound interest effect from early saving has an enormous effect. Sacrificing today is considered more painful than a worry-free retirement tomorrow.

Someone who saves today needs to put aside considerably less tomorrow. Instead of maximising the present value of one’s entire lifetime income, the here and now is overrated to the detriment of securing one’s future.

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