Behavioural finance is where money and emotions overlap, Henry van Deventer, who has the Certified Financial Planner accreditation and is head of wealth development at Old Mutual Wealth in Gauteng, says.
“If we look at how markets have performed historically versus what investors have achieved, two different stories emerge. The main reason for this is that we tend to over-think and over-analyse,” he says.
Research by investment research company Morningstar shows how investors tend to under-perform equity markets. Globally, over the 10 years to the end of 2011, equity funds provided average returns of 9.4 percent a year. Yet returns by investors in these funds averaged 4.1 percent a year. The difference can be attributed to emotional decisions, Van Deventer says.
“Five percent might not sound like that much of a difference, but if I was 30 today and investing R5 000 a month, escalating with inflation over a 30-year period, and I got 4.1 percent by letting my emotions influence my decisions, by the time I retired I’d have R7.8 million. But if I just left my money in the market and stuck to my original decision, I’d have had almost twice as much: just shy of R18 million. And that is the cost of over-thinking,” he says.
Warren Buffett, one of the most successful investors in the world, says: “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insight or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”
Quoting Daniel Goleman, author of Emotional Intelligence, Van Deventer says the keystone of emotional intelligence is self-awareness. “It’s about understanding the bad decisions we make and being able to monitor and manage our behaviour. Goleman found that IQ accounts for 15 to 20 percent of the success we achieve in life, whereas 80 to 85 percent of our success is determined by emotional intelligence.”
The same applies to investing money, he says. The five most common pitfalls when investing are: loss aversion, framing, anchoring, recency bias and confirmation bias, Van Deventer says.
Loss aversion
Loss aversion is the most common behavioural bias that investors suffer from. To explain it, Van Deventer gives an example: “Suppose I gave you R20 000 and two options. Option one: heads, I take nothing; tails, I take R10 000, leaving you with R10 000. Option two: I take R5 000 away from you, leaving you with R15 000. What’s interesting is that most people go with option one: in other words, they would rather gamble in the hope of not losing anything than have the certainty of losing something.”
Research has shown that people react twice as emotionally to losing money as they do to making money, he says. This explains, in part, why we tend to buy high, after prices have risen, and then, as prices come down, we become disillusioned and sell low. Van Deventer says we tend to repeat this process, but need not get into the habit of doing so.
“As you go into retirement, you consider what to do with the single biggest sum of money that you will probably ever have. If you mess up, the consequences are very serious,” he says.
A survey in South Africa last year shows that, on retirement, the greatest fear people have is running out of money. The next biggest fear is death, he says.
“It’s the most emotional time to make investment decisions.
“Suppose that 10 years ago, in February 2004, I invested R100 000 in the South African share market. After the market crash of 2008/2009 (it reached its trough in February 2009), I took my money out and put it in cash and, when the market recovered, by the end of 2010, I put it back in the share market. If I had done this, my R100 000 would have been worth R330 000 in February 2014. But if I had done nothing, it would have been worth R530 000.
“A R200 000 difference might not seem like a lot, but if I left this money invested for the next 20 years and got a return of six percent above inflation, my R330 000 would grow to R3.1 million, and my R530 000 would grow to R5.1 million. How big a difference will an extra R2 million make when you retire?”
Van Deventer says it’s easy to forget about loss aversion when things are going well, but when they aren’t – and our emotions start to take over – it is more difficult.
framing
To explain framing, Van Deventer uses the example of a teenager who is offered the option to save R50 a month or R100 a month. Most will choose to save R50. If, however, you ask them whether they would rather save for a Blackberry or an old Nokia, suddenly they might be willing to save more, he says.
“Framing is about the context in which we interpret and apply the information in the situations we find ourselves in,” he says.
“One of the world’s leading academics in the field of behavioural finance did a study of employees saving for retirement. About 10 or 15 years from retirement, he showed them a picture of a one-bedroom apartment without any luxuries, and a picture of a plush retirement cottage, and asked them: ‘When you retire, where would you rather live? If you want a better chance of option one, you need to save X percent of your earnings, but if you want a better chance of the other, you need to save X plus five percent.’
“There was suddenly a radical turn-around in how people looked at those financial decisions.”
Van Deventer says once you know what to expect – once you can frame what is going to go on in your investment portfolio – it becomes much easier to make appropriate decisions.
anchoring
Anchoring is when we interpret what is going on based on a specific reference point – or anchor – that we perceive to have value.
Van Deventer uses an example: “When you briefly show people the following two sums – 1 x 2 x 3 x 4 x 5 x 6 and 6 x 5 x 4 x 3 x 2 x 1 – and ask them to guess the answer, they arrive at different numbers, even though it is the same sum expressed differently. Because the second sum starts with higher numbers, people expect the answer to be higher than the sum that starts with lower numbers.”
Another example of anchoring is how we choose wines from a restaurant’s wine list, he says.
“People make an assumption that the best wines are the most expensive, and that the cheapest wines are the worst. So, if I want to buy a reasonably good wine, I’ll buy the bottle that is priced somewhere between the most expensive and the cheapest.”
When it comes to our investments, we are guided by anchors provided by the financial media, such as indices and the value of the rand, or by our investment statements, which show from one quarter to the next the value of our investments. “We let these determine whether we’re doing well or poorly. That’s wrong,” Van Deventer says.
“Whatever happened in a week, month or year, is not all that important. You should rather use personal benchmarks, such as where you started, where you are now and what you are trying to achieve over your investment lifetime,” he says.
recency bias
Recency bias is when investors evaluate performance based on the recent results of a share or on their perspective of the results and make the wrong conclusions that lead to bad decisions about how the market behaves.
Suppose you were considering buying shares in a company that listed three years ago at about eight cents a share and which are now worth 15 cents. You would probably buy it, because it seems a good investment, Van Deventer says.
“Now let’s suppose a few years later the same company that was trading at 15 cents is now trading at nine. You wouldn’t touch it.
“These values represent the rand/dollar exchange rate, roughly from 2002 to 2004 and 2011 to 2013, respectively. Looking at short terms (of less than five years or so) makes it tempting for us to change our long-term decisions. In the case of the rand, this can lead us to forget that most currencies depreciate in line with the inflation-rate differences between our economy and the economy of the currency we’re comparing. If you make calls on a currency, you need to understand what it does over the long term and why. The rand is a volatile currency and the JSE is a volatile stock exchange. So ups and downs will come, but you need to remember that, over time, you are most likely to achieve the result you hope for by looking at – and measuring your progress against – long-term investment behaviour.”
Van Deventer says you should measure information against your investment time-frame: “Whatever information you are reading, interpret it against how long you are invested for and then ask yourself: does this apply? Even if you are 60 years old, your investment term is until the end of your life. If you are 30, you have a 60-year investment term. If you are 60, it’s 30 years. If you want to make an appropriate 30-year decision, you need 30-year information.”
confirmation bias
Confirmation bias is when we react mainly to information that confirms our own opinions, Van Deventer says. “This is especially true when it comes to certain types of assets. You’ll hear people say you can’t go wrong with property’ But if you look at the numbers, there are often more effective alternatives. But we sometimes believe something so blindly that it keeps us from making more intelligent decisions,” he says.
It helps to be self-aware, Van Deventer says. If you know you have a tendency towards doing something wrong, you can catch yourself from continually doing it.
Controlling your impulses
When we make decisions based on impulse, we neglect to consider the long-term consequences of our decisions, Henry van Deventer says.
“Sadly, I know a number of people who, on retiring, will buy a Porsche – because they can.” But although they |may be able to afford it in the short term, the long-term impact on their finances may be dire.
Van Deventer points to the Absa television advert based on the famous “marshmallow experiment’ done at Stanford University in 1972.
Children between the ages of four and six were put in a room and each given a marshmallow. The children, who were filmed, were told that if they could restrain themselves from eating it until the adult returned, they could have another one. Before the adult had left the room, some had already eaten their marshmallows, but others were seen working hard to resist. The researchers then followed the children through life.
Van Deventer says the test was essentially about impulse control or delayed gratification. “The children who were able to delay gratification did better at school, fewer were obese, were more popular, more of them went to university, got degrees, got married, stayed married, and so on, all because they are able to manage their impulses,” he says.
The value of advice
Henry van Deventer says the value of financvial advice can be measured by asking three questions:
1. What returns could I achieve with or without advice?“In the future, financial advisers will most likely no longer be allowed to earn commissions on [selling] investments. You will pay them based on an agreed fee. So, if I pay my adviser one percent or half a percent [of my assets] a year, I’d ask myself: am I going to be better off with you than without you? Make sure your adviser can explain how he or she will achieve and measure results for you. If I’m going to pay someone, I want a return on my ‘investment’. My investments must also be cost-efficient and tax-efficient,” he says.
2. Can you keep me from making a mistake that would cost me one percent a year? Van Deventer says this is the biggest measure of the value of an adviser. “In my experience, people run out of money because they make bad decisions – most of the time they are lifestyle decisions, not investment decisions. For example, they buy a bigger house or car without understanding the impact on their finances. The value of an adviser is that you have someone to defer to before you make decisions that are going to cost you. You have someone to run the numbers and help you think it through,” he says.
3. Can you give me a chance at a better life? Van Deventer says there are four things that broadly determine how long your money will last: how much you save, how much you spend, when you retire and how much growth you are going to get. “The only thing your adviser can control is how much growth you are going to get. The rest is up to you,” he says.
You can do the following:
* Understand the consequences of your investment strategy. In hard times, you’ll be able to answer the question, “Is this okay?”
* Know yourself. Understand your biases. If you know you’re doing something wrong, you can change this to achieve better results. You can’t change the facts, but you can change how you react to them.
* Define what you want from your money. The million-dollar question when you retire is not how many times you are going to go overseas. It’s what am I going to do with those extra nine hours a day? And how do I make that time rewarding?
* If you are going to get advice, measure it by how well your adviser manages your strategy, including your behaviours. Make sure he or she helps you understand the consequences of your decisions, educates you, helps you master yourself as well as your portfolio, and has sufficient emotional intelligence to advise you.