Rational or irrational investment?

Rational or irrational investment? A behavioural finance explanation as to why losses hurt more than gains Dr Zaffar Subedar, Senior Research Analyst, BT Financial Group Capstone Financial Planning – February 2009

Presentation overview 1. Human behaviour – method or madness? 2. Investor behaviour – consistently random? 3. Financial planning behaviour – what methods?

Implication: Frequency of observing/ absorbing information can lead us to do things which we shouldn’t Some things are just too good to resist! • In a study, 3 groups of subjects were formed. • The first group sat 1m away from a desk of chocolate, the other 5m away and the last group 10m away. Which group do you think ate the most chocolate? Adapted from Kahneman & Tversky (1974) 1m away: 57% 5m away : 13% 10m away: 30% Human Behaviour : Method or Madness?

Style wins over substance 56,098 • Estimate the product of 8 x 7 x 6 x 5 x 4 x 3 x 2 x 1 • Estimate the product of 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8 48,748 • Can you present the same financial information in two forms? Human Behaviour : Method or Madness?

BF has been around for a while and is better at explaining how investors think and react • Behavioural Finance (BF) is the application of psychology to financial decision making • 2 Israeli psychologists in the 60’s and 70’s looked at how people make risky decisions • This research sprouted a whole new field of economics and is being implemented in industry Human Behaviour : Method or Madness?

BF is even more relevant in times of abnormal market volatility • Bernstein (2002) defines BF as … • If all investors (individuals and institutions) followed rational financial models, then return charts for assets and portfolios would be smooth “… reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty.” Human Behaviour : Method or Madness?

Not so rational New info arrives Price reflects info 13.3% fall in 5 days! 5000 4500 4000 All Ords 3500 3000 6-Oct 7-Oct 8-Oct 9-Oct 10-Oct Time (days) Markets do not process information rationally – we are all investors Rational movements $20 $16 $12 Rational price $8 $4 $0 1 2 3 4 5 Time (days) Human Behaviour : Method or Madness? 7

Behavioural Finance places science behind emotions, helping to communicate with clients • A common adage that has been used to explain volatile markets in recent months is, ‘Greed and Fear’ • Greed comes not only from desire, but also poor decision making skills • Fear comes from reflection upon those decisions Human Behaviour : Method or Madness?

In general, people struggle to make decisions under uncertainty in a rational way • Behavioural Economists applied psychological experiments in financial decision making settings • Experiments done on a variety of people; financial advisers, students, investors, executives and derivative traders Human Behaviour : Method or Madness?

Human Behaviour :Method or Madness?

Behavioural Finance is an integral component of the advice process • Financial advisers, when referring a client to an investment strategy or product must consider a client’s risk profile/tolerance • Products are catered to levels of risk tolerance – ‘Portfolio Matching’ Investor Behaviour : Consistently Random

A real 50-50 chance? • A certain town is served by two hospitals. In the larger hospital about 45 babies are born each day, and in the smaller hospital about 15 babies are born each day • As you know, about 50% of all babies are boys – however, the exact percentage varies from day to day, sometimes it may be higher than 50%, sometimes lower • For a period of one year, each hospital recorded the days on which more than 60% of the babies born were boys • Which hospital do you think recorded more such days? A. The large hospital B. The small hospital C. About the same (within 5 points of each other) D. Don’t know 35% 21% 40% 4% Investor Behaviour : Consistently Random

We don’t like to gamble in a positive frame • Imagine that the U.S. is preparing for the outbreak of an unusual Asian Disease which is expected to kill 600 people • Two alternative programs to combat the disease have been proposed – assume that the exact scientific estimate of the consequences of the programs are as follows: • If Program A is adopted, 200 people will be saved • If Program B is adopted, there is 1/3 probability that 600 people will be saved, and 2/3 probability that no people will be saved Which of the two programs (A or B) would you favour? Investor Behaviour : Consistently Random

When things aren’t looking good, we take risk, in the hope they work … • Imagine that the U.S. is preparing for the outbreak of an unusual Asian Disease which is expected to kill 600 people • Two alternative programs to combat the disease have been proposed – assume that the exact scientific estimate of the consequences of the programs are as follows: • If Program C is adopted, 400 people will die • If Program D is adopted, there is 1/3 probability that nobody will die, and 2/3 probability that 600 people will die Which of the two programs (C or D) would you favour? … mathematically, there’s no difference Investor Behaviour : Consistently Random

People do not process positive and negative information the same Difference in response to Asian Disease problemProportion of risk averse vs risk tolerant* Negative frame (lives lost) Risk averse Risk tolerant Total 69 42 111 Positive frame (lives saved) Risk averse 10 43 53 Risk tolerant 79 85 164 Total * Risk tolerance is statistically dependent on frame of question

Information overload causes investors to make decisions that are not calculated • When making a complex decision (such as an investment), with a relatively limited amount of time, people tend to use ‘Heuristics’ • Representativeness • Overconfidence Investor Behaviour : Consistently Random

Positive framing of investment decisions, changes risk attitude • After considering your risk profile, your Financial Adviser recommends two investment strategies for the following year, of which you can only select one A. A sure gain of $7,500 B. A 50% chance of gaining $15,000 or a 50% chance of gaining nothing Investor Behaviour : Consistently Random

Negative frame, different answer? • After considering your risk profile, your Financial Adviser recommends two investment strategies for the following year, of which you can only select one A. A sure loss of $7,500 B. A 50% chance of losing $15,000 or a 50% chance of losing nothing Investor Behaviour : Consistently Random

People take on more risk when confronted with losses, in an opposing situation they do not Difference in response to investment problemsProportion of risk averse vs risk tolerant* Negative frame (losses) Risk averse Risk tolerant Total 40 33 73 Positive frame (gains) Risk averse 12 64 76 Risk tolerant 52 97 149 Total * Risk tolerance is statistically dependent on frame of question

Gambling profits/gains – investors going against risk profile, becoming greedy • Imagine that your portfolio has increased by $20,000 over the year, and your Financial Adviser presents you with two investment options: A. Receive $5,000 for sure B. A 50% chance to gain $10,000 (over the $20,000 already gained) and a 50% chance to gain nothing Investor Behaviour : Consistently Random

When situations are not positive, what would you prefer to do? • Imagine that your portfolio has increased by $30,000 over the year, and your Financial Adviser presents you with two investment options: A. Lose $5,000 for sure B. A 50% chance to lose $10,000 (over the $30,000 already gained) and a 50% chance to lose nothing Investor Behaviour : Consistently Random

People do not treat financial gains and losses equally Difference in response to investment problemsProportion of risk averse vs risk tolerant* Negative frame (losses) Risk averse Risk tolerant Total 41 48 89 Positive frame (gains) Risk averse 13 47 60 Risk tolerant 54 95 149 Total * Risk tolerance is statistically dependent on frame of question

Prospect Theory shows losses hurt 2.5 times more than gains • Loss aversion is the mental penalty given to losses, which is largerthan a reward of the same size • People make decisions from reference or anchoring points • Value is assigned to gains and losses rather than wealth Investor Behaviour : Consistently Random

Ride losers and sell winners too early • Hang on to losers • Sell the winners • This allows your clients to enjoy the feeling of winning and defer the pain of loss Investor Behaviour : Consistently Random

ASX Quarterly Returns Avg Qtrly 1-yr TD Rate Inflows Outflows Myopic investors react to the market – reducing, withdrawing then ‘catching up’ with market ASX accumulation returns and retail Australian equity flows June 1993 to June 1996 Retail Equity Flows ($ millions) Returns (%) Note: Quarterly retail flow data not available until September 1994 Source: Plan for Life, Bloomberg, RBA

ASX Quarterly Returns Avg Qtrly 1-yr TD Rate Inflows Outflows Myopic investors, again react strongly to market performance, whilst cash rates just above inflation ASX accumulation returns and retail Australian equity flows December 2001 to December 2003 Retail Equity Flows ($ millions) Returns (%) Source: Plan for Life, Bloomberg, RBA

ASX Quarterly Returns Avg Qtrly 1-yr TD Rate Inflows Outflows Prolonged poor market performance has seen investors move out of growth assets, realising losses. ASX Accumulation returns and Retail Australian Equity flowsSeptember 2007 to September 2008 Retail Equity Flows ($ millions) Returns (%) Source: Plan for Life, Bloomberg, RBA

Investor Behaviour :Consistently Random?

Regret is painful, it begins to create fear and investors need someone to blame! • Regret aversion: Avoiding the pain of regret resulting from a poor investment decision • Self-attribution bias: Investors attribute performance on a variable basis • To avoid, some advisers advocate dollar-cost averaging • Time-diversification shifts fear of regret over short-run losses to optimism in long-term returns Financial Planning Behaviour – What Methods?

Short-sightedness is a major hurdle for investors Monthly 5-yearly % of Investors % of Investors Cash allocation (%) Cash allocation (%) Financial Planning Behaviour – What Methods?

Scare over enthusiastic investors with information such as this chart 1-year returns to 31 December 2008 (%) 31 December 2007 31 December 2008 Australian bonds Listed property Australian shares Global bonds Global shares Source: S&P/ASX 300 Accumulation Index, MSCI World ex-Australia (net dividends) Index in A$, S&P/ASX 300 Property Index, UBS Composite 0+ years index, Barclays Capital Global Aggregate Bond Index hedged to $A 33

Conservative investors shown the benefit of time, overcome their fixation on small time horizons December 2008 Australian shares Listed property Global shares Australian bonds Cash Note: Accumulated returns based on $1,000 invested in December 1984 Source: S&P/ASX 300 Accumulation Index, MSCI World ex-Australia (net dividends) Index in A$, S&P/ASX 300 Property Index, UBS Composite 0+ years index, Citigroup World Government Bond, Unhedged in A$ 34

How long is ‘long-term’? • Long-term is a common theme the wealth management industry articulates to investors • Long-term is different for an investor who holds stocks, as opposed to one who has managed investments • Message shouldn’t be investing to retirement, but through retirement • Young investors potentially have up to at least a 60-year investment horizon Financial Planning Behaviour – What Methods?

Very difficult to think of decisions with uncertainty, rationally Investment decisions can be processed in the same manner as other choices in every day life BF shows too much information causes people to change their course of investment action Communication can be improved by focusing on lifestyle and time horizons We can use behavioural biases to communicate and help investors from being their worst enemy Financial Planning Behaviour – What Methods?

Recommendations to assist with your client’s investment thought processes 1. Adopt a broad view of their wealth, prospects and objectives 2. Make long-term commitments to policies 3. Don’t monitor results too frequently 4. Be aware of the possibility of future regret 5. See if a course of action is ‘out of character’ 6. Have a realistic view of the odds, when a normally cautious investor is attracted to a risky investment 7. Adopt different attitudes to risk for small and large decisions Financial Planning Behaviour – What Methods?

Client Adviser Investors have an advantage – they know their own minds Advisers know facts of investments and that investors make errors There is a moral hazard on both sides of the client/advisor relationship Use advice process to protect investors from themselves, and tell them what they need to hear, not what they wantto hear

Questions

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Rational or irrational investment?