Making Rational Investment Decisions

Bias can have a powerful effect on our decision-making process when investing in unit trusts. If someone tosses a coin 10 times in a row and each time it lands on heads, then what would your choice for the 11th toss be? You may assume that the trend continues and call heads or, believing the trend will buck, you choose tails. Statistically though, there is still a 50% chance that it will land on either heads or tails.

Bias is the reason most of us tend to choose either heads or tails. When we are presented with information, we tend to interpret it according to our personal biases. Our biases and our reaction to the information may prove detrimental when we apply it to investments.

As a counter example; consider an opaque bag containing 50 white and 50 black marbles. If 10 black marbles were removed from the bag, what colour would the 11th marble be? Most of us would say white since the probability of picking out a white one is higher (50 of the 90 remaining marbles are white) than picking a black marble. Unlike the example of the coin toss above, the information we are presented with between removing the 1st and 10th marble is relevant in guiding our choices for the 11th marble.

Emotions may hinder investment success

Heuristics are shortcuts our minds develop that allow us to analyse information and rapidly make decisions. They make our lives easier, but may also lead to errors in judgement.

Scientists have identified over 100 behavioural biases. These include: Confirmation bias, which means we search for information to support our views or beliefs and over-extrapolation, which occurs when we depend too much on a particular piece of information. The more common biases we all experience are fear, overconfidence and greed.

These biases may affect your behaviour, and therefore your success, as an investor.

A good example is the investor behaviour surrounding the global financial crisis. In South Africa, the stock market yielded returns of close to 36% per year for the 5 years prior to the crash in 2008. This lured investors in droves. Many investors paid overly inflated prices, by investing at the top of the market. Then followed one of the worst sell offs in market history. Approximately R9 Billion was withdrawn from property unit trusts and equity in the first three quarters of 2008 as fear-gripped investors exited the market. This meant that investors locked in their losses.

Try not to lose your head

Investors who remain calm during times of uncertainty are often rewarded for their patience. An investment at the peak of the market in May 2008, would have incurred significant losses by November 2008. But this is not the full picture as the market recovered 2 ½ years later and any investors who did not succumb to their emotions made back any losses and, in absolute terms, more than doubled their money by September 2016.

Don’t toss coins, pick marbles

Many people who invest use the same heuristics as they do for the random coin toss. This often results in a poor outcome. However, assessing information and using it where relevant (i.e. the marble in the bag approach) tends to yield better results.

How can we overwrite these biases? Believing the investment philosophy developed by your investment manager and understanding the unit trust you invest in makes it a bit easier to sit through market fluctuations. This allows you to benefit from the upswing when it does come around. Rational thought over emotional response is vital to a successful investment.

Find an investment strategy that is tailored to your needs, risk tolerance and time horizon. This will help take the emotional element out of your decision-making. Long-term strategies should not change if markets are volatile. An independent financial advisor can help you stay focused on your goals even when your emotions threaten to overpower you.

 

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