Switching on the value lightbulb

Shaheed Mohamed, Investment Specialist at Allan Gray

Is your client’s behaviour standing in the way of their investment success? In this article we will explain how becoming aware of common biases can help clients improve their chances of achieving better returns.

If a coin is tossed ten times in a row and lands on heads for each of the tosses, what would your choice be for the eleventh toss? Some may guess heads, assuming that the trend will continue, while others may choose tails, believing that the trend must buck. But statistically there is still a 50% probability that it will land on either heads or tails.

Personal bias
The reason most people tend to favour either heads or tails is simple; they are bias. When presented with information, we interpret it according to our own biases and then react to that information. However, this can be detrimental when applied to investing.

Consider a counter-example: an opaque bag contains 50 white marbles and 50 black marbles. If you removed ten black marbles in a row, what would be your guess for the eleventh go? Most people would select white because there is a higher probability (50/90) of selecting a white marble than a black one.

Emotional influencer

Our minds develop short-cuts known as heuristics that allow us to make decisions quickly. Although heuristics make our lives easier, they can also sometimes lead to errors in judgement.

Some of the over 100 behavioural biases that psychologists have identified include over-extrapolation, which is essentially relying too heavily on one piece of information, confirmation bias. This involves searching for new information that supports one’s beliefs and the better-known biases of overconfidence, fear and greed.

These biases can influence your client’s success as an investor. Remember the bias of the South African investor behaviour in the lead-up to and shortly after the global financial crisis?

For the five years prior to the crash in May 2008, the stock market returned close to 36% per year. This lured investors in droves. Many of these investors invested at the top of the market, paying overly inflated prices for individual shares. This was followed by one of the worst sell-offs in the Johannesburg Stock Exchanges (JSE) history resulting in R9 billion being withdrawn from equity and property unit trusts in the first three quarters of 2008 as many investors exited the market in fear, locking in losses.

Don’t lose your head

Investors who keep their heads in times of uncertainty are often rewarded.

An investment of R10 000 in the FTSE/JSE All Share Index (ALSI) at the peak of the market in May 2008 would have been worth R5 465 at the market bottom in November 2008.
However, that is not the full picture: the ALSI recovered two and a half years later. Investors who did not succumb to emotions would have made back their losses and more than doubled their money in absolute terms by 30 September 2016.

Pick marbles, leave the coin toss

When investing, many people use the same heuristic as they do for a random coin toss, often resulting in a poor outcome. However, following a marble from the bag approach, assessing information and using it when it is relevant, generally results in better outcomes.

So how can you help your clients overcome their own inherent behavioural bias?

The key is to get your client to buy into the philosophy underpinning the investment manager’s approach, and understanding the unit trust he/she is invested in. This makes it easier to sit tight through market cycles and benefit from the upswing when it comes.

Talk to your client about how their investment strategy ties into their objectives. This will help them realise that sticking to their strategy will take the emotion out of decision-making. A long-term strategy should not change when markets turn volatile.