Irrational investors are overconfident and they hear what they want to hear

By Chris Hutching

Friday 24th May 2002

How can investors and their advisers strip away the irrational bias that often accompanies investment decisions?

This was a question explored by Barclays Global Investors adviser services directors Cathryn Wise and Michael Ohlsson at a recent financial planning conference in Christchurch held by Australian-listed investment advisory network Count Financial.

Mr Ohlsson reminded delegates that sometimes investors had a faulty assessment of their own wishes and they needed to be fully discussed to clarify their aims. This might require a different investment strategy from the one clients initially envisaged.

Main impediments to good investment decisions included overconfidence, optimism, hindsight, reacting to chance events, "hearing what you want to hear" and failing to view the long term.

It was important for financial advisers to point out investment uncertainties or risk thwarted expectations.

Investors may find it difficult to accept that chance events such as the September 11 terrorist attacks or natural disasters are one-off events and they tend to overreact. Most people prefer not to hear about the risks of the downside but financial planners would be failing their clients and themselves not to point them out while noting that paper losses are not losses unless the investments are cashed up.

Changing events often look predictable in hindsight to the extent that people often later proclaim "it was inevitable."

"But psychological evidence indicates that people rarely recall after a major event just what their views were beforehand," Mr Ohlsson said.

A way around this is for clients and financial advisers to keep file notes of their discussions as to why a growth stock or some other investment was chosen. But Mr Ohlsson said it was also important to realise there was a limit to the amount of advice people would accept.

He said financial advisers should talk about market volatility with clients and remind them of the bad times during the good times.

"Recent events in equities markets are quite normal in the long term," he said, noting that the average price-to-earnings ratio of Australian stocks was still high at 25.

Cathryn Wise said most people were biased toward optimism, with tests suggesting 80% of people thinking they were above-average in skills such as vehicle driving.

"We tend to exaggerate our talents and under-estimate bad outcomes to promote the illusion we're in control," she said.

One of the biggest illusions was the notion that games of chance involved skill, she said. Applying this to investment decisions meant recognising that recent performance of a managed investment fund was no guarantee for the future.

Ms Wise recommended planners and clients keep a list of unsuccessful ventures to assess what went wrong rather than simply forgetting the episode.

One way of overcoming investor nervousness about particular forms of investment - for example, equities - might be to introduce them slowly beginning with a small investment until clients were comfortable about making further adjustments.

"Investors who own riskier assets must commit psychologically to an equity investment timeframe, such as five years. There's no point in recommending an equity portfolio to someone who will be constantly worried about short-term volatility."

One of the most dangerous periods for investors was during times of high market performance because it could lead to over-confidence, she said.

Clients and planners should agree on how frequently they received reports and how much information was required, she said. Some investors were focused on quarterly returns but for others it might be a longer-term horizon.

"It's important to agree on procedures to avoid knee jerk reactions to market events because often clients will have access to investment information at any time through the internet."

When major events did occur, most financial planners would have systems to supply clients with electronic or faxed newsletters to keep clients informed, she said. This was evident after September 11 when many funds managers and investment service firms sent newsletters to clients on the same day to reassure them and give examples of what had happened during previous periods of high volatility or spectacular events.

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