Perceptions of value: Understanding behavioural biases in investment decisions
As investors, our emotions and perceptions can significantly impact our investment decisions and outcomes. In this piece, we explore how behavioural biases—like loss aversion, framing, and anchoring—can shape our views on investment performance, often leading to suboptimal choices. Drawing on recent insights from the Paris Olympic Games, we illustrate how these biases manifest in investment behaviours and discuss their implications for investors in New Zealand.
The Olympic analogy: Lessons in value and perception
We had the pleasure of seeing the world’s best athletes competing at the Paris Olympic Games during the quarter. There are many analogies to investing that can be drawn from the Olympics, such as a diverse group (fund managers or athletes) all competing to be the winners (financial or otherwise)
However, we’d like to draw your attention to how the medal winners felt about their achievements. At first blush, you’d expect this would be an easy question to answer – happiness would be in line with the medal that you won. In simple terms, gold medal winners would be the happiest, then silver and bronze medal winners.
Well, as it turns out, this is not quite accurate. A study[1] of medal winners found that bronze medal winners were happier than silver medallists (both at the immediate conclusion of the event and later on the podium). The most obvious question is: why would a bronze medal winner be happier than the silver medallist who beat them?
The reason is that people’s happiness is not simply a function of the result, and in this case the medallist’s happiness was affected by “counterfactual thinking”, or put more plainly, thinking about “what could have been”. The silver medallists’ happiness was lowered because the most easily imagined alternative is that they had just missed out on a gold medal, whereas the bronze medallists most easily imagined alternative was that they placed 4th and would not have won a medal at all. More simply, silver medallists considered they had “lost” the gold medal, whereas bronze medallists believed they had “won” their bronze medal.
Delving into a bit of psychology, the reason for this behaviour is due to humans feeling a loss more intensely than an equivalent level of gain. There is an evolutionary basis for this behaviour but in summary humans have become conditioned to be very sensitive to loss so they will try to avoid it. This behaviour is called “loss aversion” and is a known behavioural trait.
While this may be of (mild) interest to some, the wider question is why this is relevant for investors. The answer is that people’s emotional response to investment will affect their long-term investment performance and as such needs to be considered and monitored.
Just as Olympic medallists’ happiness is not a direct reflection of their actual performance, investors’ perception of how well their investments have performed is not a direct reflection of their risk adjusted returns. An investor’s happiness about their investments will drive their subsequent investing actions – either remaining invested, contributing more, changing investment strategies or even withdrawing from the markets completely. The risk is whether those investment decisions improve or detract from achieving your investment goals.
Why feelings matter
Imagine you are at a barbecue and the conversation turns to investment returns. You’ve had a pretty good return for the year and are quietly happy with your finances. If you overhear that someone else had a much higher return: would you now feel happier, less happy or about the same? It would not be unreasonable to feel less happy as you may think you’ve somehow missed out. Alternatively, if you had a poor return but overheard someone else bemoaning a much worse result, you may feel slightly happier. However, in both cases you probably don’t know enough about the other person’s investments to have a considered opinion about whether you have done better or worse. Likewise, someone else’s good past performance is unlikely to have any bearing on your future performance.
Regardless of whether you take any immediate action after the conversation, a seed would have been planted as to how happy you are about your investment, and your future dealings will be affected by that initial feeling. This is related to the behavioural concepts of framing and anchoring. “Framing” is a cognitive bias that describes how a person’s decisions are influenced by how information is presented, rather than the actual content of that information. “Anchoring” is also a cognitive bias that causes people to rely too heavily on the first piece of information they receive on a topic and use that information as a reference point for all subsequent judgments.
Again, this may strike you as (mildly) interesting, but how does it affect investors?
Loss aversion, framing and anchoring biases impact decision-making subconsciously and in doing so can have serious implications on the quality of decisions that are made. From an investment perspective, this can lead to suboptimal (poor) investment decisions.
Minding the gap
We can see the impact of sub-optimal investment decisions on investor portfolios in a recent report “Mind the Gap[2]” by research firm Morningstar. It revealed exchange traded fund (“ETF”)investors in the US lost over 1% each year compared to managed fund investors and this “stems from mistimed purchases and sales and is broadly in line with the gaps measured over the four previous rolling 10-year periods in prior studies”. Putting that 1% per year into perspective, it equates to about 15% of the return generated by the investors’ funds.
The report spanned more than 20,000 fund share classes that accounted in aggregate for more than US$12 trillion in net assets at the start of the 10-year period and nearly US$21 trillion (by the way – a truly staggering figure) by the end. Over that period, investors withdrew a netUS$1.9 trillion in assets from those funds covered by the report over the decade ended 31 December 2023. In the study, Morningstar measured the real average return investors received each year – based on product cash flows – against the reported headline performance of funds.
The report found the gap was consistent across asset classes and persisted over a long time period, noting: “We found shortfalls between the average [actual] dollar's return and the average [theoretical] return which would have been achieved with a buy-and-hold mindset in all 10 of the calendar years that comprised the 10-year study period. Investors particularly struggled to navigate 2020's turbulence, adding monies in late2019 and early 2020, then withdrawing nearly half a trillion dollars as markets fell, only to miss a portion of the subsequent rally.” The gap was notably pronounced in 2020, a time when COVID fears gripped the world and share markets were especially volatile, leading to a negative 2% gap that year.
It was investor decisions, affected by behavioural biases, that were the cause of the investment gap. Those investment decisions had a direct, material and adverse impact on their investment returns. Mark LaMonica, Morningstar Australia’s personal finance director noted “Many people assume that investing in passive investment vehicles that track a well-known index means that they are insulated from the behavioural risk that leads to the gap. That is not true. It is how you use these passive vehicles. Periodically selling one passive ETF and buying another is an active investment decision. Making adjustments to how much is saved and invested in a passive vehicle based on market conditions is making an active decision.” Somewhat counterintuitively, Morningstar did not find a link between fees and investor underperformance relative to fund-level returns.
There was one bright spot in the report. Investors in well-diversified “all-in-one allocation” funds such as those in the Integral Master Trust experienced the smallest performance gap due to these strategies automating tasks like rebalancing, resulting in fewer transactions that could be affected by investor biases.
Even with a well-diversified, comprehensive investment product such as the Integral Master Trust or the Britannia Retirement Scheme, it is still important to be vigilant about how behavioural biases may impact your investments. That is the role of your financial adviser. By acting as a reviewer of investment decisions, questioning and highlighting any biases that may be motivating decisions and providing context to address those biases, advised investors are better able to capture investment returns, understand their risks and achieve their financial goals. By countering investment biases and choosing investment products carefully, financial advice can aid investor performance year after year.
The information contained in this publication is intended for general guidance and information only. It has not been personally prepared for you. Therefore, you should not act on this information if you have not considered the appropriateness of this information to your personal objectives, financial situation and needs. You should consult with us before making any investment decision. Historical market performance may not be indicative of future market performance.
[1]When less is more: Counterfactual thinking and satisfaction among Olympicmedalists. Journal of Personality and Social Psychology Medvec, V. H., Madey,S. F., & Gilovich, T. (1995).
[2]Mind the Gap 2024, Morningstar, 15 August 2024