Investor Emotion and Cognitive Biases
Individuals and businesses around the world experience various cycles associated with health, work and many other day-to-day occurrences. Investors aren’t any different, and many are currently going through a very tough period within the investor cycle, experiencing financial loss with their investments as the Coronavirus pandemic has turned into a major economic downturn. This is when investors need to understand that markets are indeed cyclical and forget that in a cycle there is always a downturn.
Regardless of how the markets react to political, environmental or economic news, the important thing for investors is to not react in an impulsive manner as investor emotion and behavioral basis can cause investors to make irrational decisions with their investment portfolios.
In some cases, cognitive biases may be the result of heuristics, which are mental ‘rules of thumb’ used by investors and others to make decisions. In many situations, particularly where individuals are having to make decisions under time pressure, or are unfamiliar with the subject matter, they will rely on such rules of thumb to allow them to make a quick decision.
The different stages of the investor-cycle are represented by the different colours depicted below:
The first four emotions on the graph can relate to the mark-up phase of the market cycle, which is when the market has been stable for a while, heading in an upward direction, with more investors jumping on investor optimism.
Optimism is the first investor emotion on the graph as investors see an opportunity to buy into the market. As their investment continues to grow with the upward swing in the markets, they begin to experience a sense of excitement as performance is realised. Just before the cycle reaches the peak, investors experience the thrill as their investment continues to grow and produce quality returns.
Finally, euphoria sets in when valuations climb well over historical figures and investors couldn’t be more satisfied with how their investment is performing. The point of maximum financial risk is reached.
A cognitive bias that can affect decision making towards the peak of the cycle is the herd behaviour bias (also called herd mentality, crowd psychology or the bandwagon effect). This describes the tendency for individuals to mimic the actions of others (often larger groups) and often results in individuals making decisions that they would otherwise not have made on their own, often generally accepted because decisions are perceived less likely to be incorrect if more people buy into them. Such behaviour can be even more prevalent where the individual has little knowledge or expertise in the area in question.
The second phase of the market cycle is where the bullish sentiment from the mark-up phase turns to a mixed approach. This can be a very emotional phase, as the approach to either sell off or buy can toil with investors’ emotions.
Investors start to experience anxiety, unsure of what to do after a period of strong growth, and a temporary setback in the markets should not bring any worry. A sense of denial kicks in as many accept the long-term approach and continue to look towards the markets in the hope for improvement. If this improvement doesn’t come, fear and eventually desperation kick in as investors worry about their portfolios venturing into the negatives and losing the gains from the previous upswing.
The initial stages of the distribution phase can cause investors to seek information about their stocks and investments. What is the reason for the downturn and how it will affect their individual stocks or overall portfolios?
In the case of confirmation bias, individuals are more likely to search for information that confirms their existing position than contradicts it, or perhaps interpret ambiguous information as supporting this viewpoint. As a result, they ignore potentially useful information that refutes their preconceptions.
Here is an example: Based on a rumour that XYZ plc. is about to declare bankruptcy, an investor considers selling their stake, but before doing so they go online to read the latest news about the company. They only read stories confirming the likely bankruptcy scenario, in turn missing one about the imminent launch of a new product that is expected to increase XYZ plc’s sales and, therefore, profits. As a result, the investor sells the stock at a depressed level before the shares turn around and climb to a fresh all-time high. This is confirmation bias.
The next phase in the cycle is the mark-down phase. Many have continued to hold onto their investments, despite the share price falling below what they originally bought it at in the hope of the markets rebounding.
Panic sets in as investors have no idea what to do with their investments. Many count their losses after feeling capitulated and despondent towards the financial markets, with the outcome being that the markets “aren’t a place for me to invest my money” and “if only I had sold off earlier”. Hindsight becomes a reality for many individuals at this point, and depression kicks in after the realisation of what was lost and what should have been done.
One particularly significant example of an emotional bias that can relate to despondency is that of loss-aversion. Repeated studies suggest that, rather than being risk-averse, investors are loss-averse. In other words, investors do not experience gains and losses with equal intensity; rather, they experience a greater degree of emotional discomfort from a loss than the positive emotions they experience from a gain.
As an example of the concept of loss-aversion, in one study participants were given a choice between: “A certain gain of $500 or an equal chance of winning $1,000 or nothing at all.” They were then given a choice between: “A certain loss of $500 and the alternative of an equal chance of losing $1,000 or losing nothing.”
In response to the first question, participants were generally more willing to take a certain gain than to take the chance of winning more. However, in response to the second question, participants were more willing to take the risk than to accept the certain loss.
In other words, they did not wish to take the risk when a certain gain was available but were willing to take additional risks in order to avoid a certain loss. If true, the concept of loss-aversion has important implications for those who invest on behalf of clients or advise clients regarding their investments. For example, it suggests that clients are not only (understandably) unhappy about losses on their portfolio, but that they feel the impact of these losses more intensely than the equivalent gains generated by their portfolio.
The bottom of the market and the investor cycle is the trough, and this point can be identified as the point of maximum financial opportunity. The market has said to have bottomed-out at this point, with experienced investors seeing this as an opportunity to invest and get their hands-on undervalued shares, leading to the emergence of phase 4.
The accumulation phase sees a renewed sense of life in the markets. With the end of the depression, the markets look forward to a much-needed upward swing in the cycle and for investors, the worst is behind them as market sentiment begins to make the change from being negative to positive. Hope is restored in investors as news spreads around the world in order to build investor sentiment.
Followed by the good news, relief is felt by many as the worst is over, and their investments begin the rebuilding stage. Those who held onto their positions through the downward swing begin to see the light at the end of the tunnel. Others begin the research process as they look to capitalise on low price earnings ratios. Optimism is renewed and from there the cycle starts again.
A common cognitive bias that can be associated with this phase in the cycle that causes such emotions is availability bias. This is where investors tend to give more weight to information that is easily available to them.
At this stage many believe the information that they first read about an upward swing is sufficient enough for them to make a decision, and because an individual can easily recall particular information regarding a topic (perhaps because it was recently featured in a newspaper or other publication), this information will have a significant effect on any relevant decision that the individual is required to make.
In one study, subjects were asked the following question: “If a random word is taken from an English text, is it more likely that the word starts with a ‘k’, or that ‘k’ is the third letter?”
Most people would find it relatively easy to think of words that begin with a ‘k’ but would find it more difficult to think of words which have a ‘k’ as the third letter. However, in reality, words which begin with ‘k’ are used much less frequently in an average piece of text than words which have a ‘k’ as the third letter.
The concept of availability suggests that individuals make judgments based on what they can easily recall, and this is supported by the results of this study, in which participants overestimated the number of words that began with the letter ‘k’, but underestimated the number of words that had a ‘k’ as the third letter.
As a final note, remember that investing in the financial markets always comes with periods of ups and downs, and much like the market-cycle, the investor-cycle will experience extreme highs and extreme lows, with the important point being the way an individual handles these periods and all of the emotions that come with decision making.