By ADRIAN LOWCOCK 26/02/2009
Investment decisions are frequently made in situations of high uncertainty that preclude dependence on fixed rules and compel the decision-maker to rely on intuition, indeed intuition plays a crucial role in many decisions. There are cognitive illusions and biases that affect investment decisions. Investors are all prone to these biases and if unaware of them we will take risks that we are unaware of, experience outcomes that were unanticipated and may end up making irrational investment decisions that can hit us where it hurts, in our pockets.
Overconfidence
The phenomenon of “anchoring” or “framing” is one such example of this irrationality. In the absence of better information, investors will assume current prices are correct. This tendency to stick with an initial point of view can and is exploited by companies when reporting. Often company reports will contain positive messaging using powerful words including; grow, good, better or improvement, less often are occurrences of tone suggesting there may be issues or risks within a company. This form of presentation could easily influence the opinions formed by investors and reassure them that their first decision was correct and may lead to over confidence - a dangerous attitude for investors and fund managers alike. What is required is a system to calibrate against i.e. get regular, prompt and clear feedback to help make an informed choice.
So how do you know if you are well calibrated? Pick a high value that you are 99% sure the FTSE 100 will be a month from today and a low value you are 99% sure of. You now have a 98% subjective confidence interval i.e. the likelihood the FTSE 100 will rise above or below your estimate is 1% each way. If the FTSE 100 at the end a month falls within your parameters you are well calibrated. This exercise needs to be repeated with a large set of unrelated propositions to provide an accurate picture.
Unsurprisingly most people are not well calibrated, but perhaps what is surprising is that studies indicate only 2% are well calibrated. This demonstrates level of widespread overconfidence. While these conditions may be met by some financial professionals they are never likely to be satisfied for non-professional investors and therefore non-professionals are more prone to overconfidence.
Optimism
Optimism is not something many would expect to see at the moment but most people tend towards being optimistic. For example the majority of people (80%) think they are above average drivers, which of course means many will be wrong. Likewise optimists underestimate the likelihood of bad events affecting them, and would see themselves as less likely than their friends to develop cancer or have a heart attack. Optimists frequently believe they have a greater level of control over affairs and therefore underestimate the role chance plays in everything we do. Combine overconfidence and optimism and you have dangerously strong force which causes investors to overestimate their knowledge, underestimate the risks and retain a belief that they are still in control.
Hindsight
Hindsight is a wonderful thing, a phrase we have heard and used time and again. But how sure are we that our recollection of our views the day before an event are entirely accurate and haven’t been influenced by the current events? Industry experts are frequently heard commenting on the movement of a market and providing rationale after the event, thus an investor may well believe that the market acted rationally and predictably, even though it did not. This hindsight encourages further overconfidence, making the world seem more predictable than it actually is. This in turn leads to a second consideration. What seemed a reasonable investment is turned into a foolish gamble as hindsight makes the events seem inevitable and obvious leaving many overconfident investors to ask why their adviser didn’t suggest selling beforehand and even more dangerously believe that they are able to make more competent decisions than the professionals. The evidence suggests otherwise and investors need to work with professionals to ensure they have a well diversified and robust portfolio or they may end up coming back into the real world with a bump!