I don’t know about you, but I find psychology rather fascinating. It’s interesting that certain external factors and cultural distinctions can influence our behaviours so dramatically.
And let’s face it, how humans behave has a major impact on the world around us, particularly when it comes to our financial fortunes and investment markets.
Consider property for a moment and the cyclical nature of our housing markets, which is largely determined by consumer sentiment, among other economic fundamentals.
It’s called ‘the herd mentality’ for a reason. When everyone seems to be positive and upbeat, happy to part with their money for a large, life changing purchase like residential real estate, it seems we all generally feel the same warm, fuzzy and positive consumer glow.
Likewise, when things start to transition and media messages are full of negativity, people tend to lose confidence and become a little more Scrooge-esque with their bank accounts.
Standard economic modelling tends to assume that people make decisions by logically weighing up all the variables and available information. However, this doesn’t account for human emotion and what psychology experts refer to as ‘behavioural bias’.
More studies are being conducted on a global scale to assess the decision making process, in a bid to provide a better reflection of how human behaviours influence financial markets, as opposed to the common theoretical models of how markets should operate – if we were all robots.
Remember I mentioned ‘herd mentality’? ‘Herding’, as the experts call it, is one of the things that can influence investors to make decisions that on any other day might seem a tad irrational. But they get caught up in the pervasive fear mentality and all reasoning goes out the window.
A 2012 article published in the Journal of Investing by Todd Feldman, entitled The Most Destructive Behaviour Bias, sought to test four behavioural biases that can cause investors to make poor financial choices, being:
1. Overconfidence – those investors who believe they are superior decision makers and are therefore more likely to take risks with their investments.
2. Recency or anchoring – investors are inclined to make future decisions based on immediate past events, believing future outcomes will directly correlate with recent occurrences.
3. Loss aversion – the experience of a perceived ‘loss’ can feel more pronounced than gains to some investors, so they avoid making decisions considered ‘too risky’, or react and sell assets in the wake of market negativity.
4. Disposition affect – this is essentially where you sell your ‘winning’ assets early and hang on to your ‘lemons’ for far too long.
Feldman studied four groups of investors who displayed these specific behavioural biases and applied their decisions to a ‘virtual investment market’; in order to examine how they’re actions influenced the simulated environment.
Depending on their bias, a different amount of funds were invested in equities, as opposed to cash and the investors rebalanced at the end of each period based on share market moves and their methods of investment.
For instance, each month the rational investor would rebalance their investment portfolio back to where they started, based on the long-term variance of the share market. So if the initial investment was based on a 60/40 split in favour of equities, they tried to maintain this.
Whereas the recency investor would consistently look to yesterday to make his or her decisions, putting less emphasis on long-term fundamentals. Therefore, if the market experienced a period of volatility, they were more likely to decrease their equities investment based on the assumption that the recent market instability would continue.
If the market took a bit of a battering, the loss averse investor also pulled back on their equities investment, attempting to lower their exposure. While the disposition investor either bought more or hung on to everything while the market was falling, before selling it all as things started to pick up.
Feldman concluded that the various behavioural bias displayed by the investor groups had a significant bearing on their success in the simulated investment market.
Overall, portfolios owned by those investors who focused on recent events to make their decisions were the greatest underperformers, with the loss averse and disposition investors still not faring as well as the rational investor, but doing slightly better than the recency investor.
Interestingly, the amount of trading carried out was different to each investor group, yet did not determine overall success at the end of the day. The loss averse investor was the most active and ended up with additional transaction costs as a result, but not the best performing portfolio.
What it means for property investors
Although the Feldman model focuses on equities as an investment vehicle, the findings have significance to all investors, including those who trade in residential real estate.
Understanding your own personal behavioural bias is an important aspect to the planning process and in particular, devising an appropriate risk management strategy when it comes to growing your investment portfolio safely.
The more knowledge you have, the less likely you are to be influenced by such biases and instead, make clear, rational decisions guided by your long term objectives and investment roadmap.
Investing requires a disciplined, rational approach, and knowing who you are as an investor will make all the difference when it comes to whether you act from insight and understanding or react from emotion and fear, when presented with different market movements.