Human errors may cause poor investment decisions
There are a multitude of factors which determine the performance of a share, including whether a fund manager should be adopting a passive or an active investment strategy. However, how much of a role do human thought patterns play in this field and how does this damage an investment strategy?
People find it difficult to separate rational thoughts from an emotional attachment. Considerable time, effort and money have been dedicated to the study of human nature and there are some thought patterns which can be changed. If fund managers and investors can identify and change these patterns, financial success may be easier to achieve.
Embracing basic errors
If you had to go out and ask a group of people if they are better than the average population at a specific task, the majority of them would reply yes, they are. This is called self-enhancement and it is a thought pattern that every person follows which is closely linked to self-confidence.
However the reality is that at least half of us are worse than the average we feel comfortable beating. If everybody was better than the average road user, then how high would the bar be set?
Self-enhancement could seriously hurt an investor if they are adamant that they are better than the average investor. Statistics show that the market is seriously constricted and that even the best fund managers face challenges to beat the market.
If a person is not beating the average, they will at least want to keep up with the average. The same goes for investments, no investor or fund manager will aim to underperform. Because of this, people automatically revert to loss aversion. They are more scared of losing money than gaining money. People rank a 10% chance of a loss more seriously than a 10% chance of a potential gain.
This kind of thinking could potentially be harmful to an investment outlook. Take for instance this scenario: there is a stock that is losing significant value in the short-term, but indications are that this will correct itself and show significant gains over the long-term. Would you purchase the stock? Or would self-enhancement cause you to revert to loss aversion because the voice in the back of your mind is screaming at you that the risk is too high?
The dual problem of anchoring and herding
Most people tend to have a negative thought pattern by placing undue weight on the first piece of information they learn about something. For example, if you eat at a restaurant where you receive bad service you likely to never go back there again. If you go into a shop and receive bad service, you are also likely to never go back there again.
We use this information as an anchor and we link all subsequent expectations to it. This is unfair because what if the waiter at the restaurant or the attendant at the shop was a trainee? It is hardly a reflection on the establishment.
The same can be said about investing in stocks. At times, we get flooded with information about a stock which will completely put us off it. Take the example discussed at the end of the first section. Anchoring is closely linked to the loss aversion thought pattern. No matter how well that stock improves, anchoring will tell you there is something inherently wrong with that stock.
Most people have heard the urban legend about lemmings that follow the rest of the herd to jump off cliffs in Scandinavia. The same applies to individuals today. A group of people purchases stocks in a specific field, it performs well for a sustained period of time, and more people follow and buy similar stocks in that field. The strong performance of the field continues, enticing more and more people to buy stocks. This is the main cause of stock market bubbles. A group of investors panic because of loss aversion and sales. Prices then fall, which causes mass selling. The bubble then duly bursts.
Overcome these factors
Bypassing these factors is not as easy as it seems. Negativity bias means that people rank bad news as more important than good news. The poor performance or steep fall in share price, of a stock will make people shy away from it. Negativity bias is a precursor to loss aversion. If an investor or a fund manager focuses on bad news, they may be pressured to sell a stock when there is a temporary correction or a bad quarter.
Confirmation bias means that some people will purposely look for pieces of information which will validate their choice in selecting something. This is a problem because you will turn a blind eye towards information that points to the bubble of a specific group of shares bursting.
Editor’s Thoughts:
The study of human thought patterns does contribute significantly to resolving poor business decisions. If investors and fund managers actively try and avoid the thought patterns pointed out above, the reports about the poor performance of South African active fund managers can be overcome. Please comment below, interact with us on Twitter at @fanews_online or email me your thoughts [email protected].
