Craig HobartAfter receiving average annual returns of around 25 per cent for four consecutive years, Australian share investors have experienced a rude shock over the past two financial years, with  the S&P/ASX 200 Accumulation Index falling 13 per cent in 2007-08 and 20 per cent in 2008-09.

With equities representing around 60 per cent of a typical balanced fund (including international equities), superannuation funds have also been severely impacted. The impact cannot be   under- stated, with the market fall-out taking a huge toll on investor confidence. Investor confidence, emotions and psychology play a vital role in driving market upturns and downturns.  Investors have gone from feeling highly optimistic, with the sharemarket regularly reaching new record highs in the period 2004-2007, to extremely pessimistic, with the market falling to  five-year lows in March 2009, resulting in many investors seeing their investments fall sharply in value. Periods of high optimism or exuberance are generally associated with greed while  pessimism is generally powered by fear.

It could be argued that greed not only propelled the market to record highs, but ultimately the pursuit of higher returns and income through the wonders of financial engineering, masquerading as defensive  assets, eventually came undone – proving that the old adage of “higher returns means higher risk” is actually true. The crisis has also proven that markets do move in cycles (despite calls to the contrary as recently as 2007 by the then UK Chancellor of the Exchequer, Gordon Brown); and while the drivers of booms and busts may change, investor behaviour doesn’t.

Since the onset of the global financial crisis in July 2007, many investors have been in the grip of fear, paralysed to act not wanting to crystallise losses or make the wrong decision, leading to inertia in some cases  nd just plain bad investment decisions in others. Many of us will undoubtedly look back on this time and realise it was a wasted opportunity, with many stocks representing exceptionally good value. This article explores some typical investor behaviours and the role they play in influencing investment decisions. Whether we realise it or not we all probably exhibit these behaviours – even well-known market  theorist Harry Markowitz was known to.

Modern portfolio theory assumes that markets are efficient, and that all known relevant information is priced in to the value of shares. This means that shares always trade at their fair value and therefore there  aren’t any opportunities for investors to generate excess returns – either through stock selection or market timing. Another critical assumption in the hypothesis is that all investors are rational.

Behavioural finance theory, which had its formal beginnings in the 1980s and became a main- stream economic theory in the 1990s, takes a different view. Far from assuming investors are rational, it deems them  to be irrational in their behaviour, often making investment decisions based on emotions, previous experiences or a fear of regret. This can result in investors making investment decisions unrelated to the future potential of that investment, causing its share price to trade at a discount or premium to its fair value. Active fund managers disagree with the notion that the market is perfectly efficient, believing that all  information is not necessarily available to every- one, and even if it were, it is interpreted differently by market participants, and therefore isn’t always built into a company’s share price.

Many also believe that irrational investor behaviour plays a role in forming market inefficiencies, thereby creating investment opportunities – but not every opportunity is necessarily a profitable one. There are  many causes of inefficient markets. One is known as “heuristic bias”.


Heuristic biases are essentially “rules of thumb” gained from previous experiences. These experiences create a natural bias based on a previous experience, rather than logic. For example, a person may decide  not to go to a particular destination for a holiday in the belief that it’s a rainy city, because the last time they went there it poured with rain. The person does not consider the average rainfall or other long-term statistics. Or an investor who lost a lot of money in a single mining stock might never invest in mining stocks again in the belief that their previous experience will be repeated. This may seem like reasonable  behaviour, but it is often based on singular experiences rather than logic. One experience does not necessarily mean it will always happen again.

There are a number of heuristic biases. Two of these – representativeness and over-confidence – are discussed in more detail below.


Representativeness bias occurs when investors make decisions based on pre-conceived ideas or stereotypes. A typical example of this is “gambler’s fallacy”, such as when a punter believes that after six heads in a  ow, tails must be next. There is no logical reason why tails “has to be next”. The likelihood of either heads or tails occurring is exactly 50 per cent, but they continue to hold the belief that their turn is due. This  belief is based on the theory that over the long term, there is a 50 per cent chance of a tails or heads coming up – but there is no ability to know when that will occur. The problem is the punter is applying a  long-term theory over a very short- time horizon. It really comes down to how long the punter is willing to wait and how much money they are pre- pared to gamble to see tails come up.

Another example of representativeness heuristic bias is an investor’s decision to buy the latest hot stock. This was no more apparent than during the tech boom in the late 1990s and early 2000s when technology  tocks were seen as the new paradigm and “old economy” stocks were out of favour. Many invested on a pre-conceived idea that all tech stocks would per- form well – without fully assessing a company’s earnings potential.

Sure there were some good quality technology stocks, but there were some very poor ones as well. Unfortunately they were all lumped together and treated the same. This was a prime example of the “herd  mentality” at play, with investors getting caught up in the momentum and not wanting to miss out on the next big thing, especially when all of their friends and family were also investing in these stocks – so they  followed the crowd and also bought technology stocks. Unfortunately many investors hopped on the bandwagon too late and suffered the consequences of the subsequent “tech wreck”.

In the US, after reaching an all- time high in March 2000, the bench- mark technology index, the Nasdaq Composite Index, fell by more than 50 per cent within a year. According to behavioural finance experts  Werner De Bondt and Richard Thaler, this representativeness heuristic bias means investors can be over-optimistic about past winners and over-pessimistic about past losers. This favouritism of past winners  and bias away from past losers causes markets to deviate from fair value, with the former becoming overvalued and the latter becoming undervalued. They also argue that this mispricing is a short-term phenomenon, and over time the losers will outperform the general market and the winners will underperform.

Let’s look at an example of the dangers of favouring past winners. In chart 1, the first diagram shows the five top performing stocks in 2007 in the energy sector within the S&P/ ASX 200 Index. As the bars in the  chart show, all five stocks outperformed the energy sector that year. From these numbers, without undertaking proper due diligence, one could make an assumption that these five stocks must be of high quality  as the market has supported them, and therefore they will continue to outperform their peers.

This was not the case. In 2008, there was a marked change in performance with the same “basket” of energy stocks not only significantly underperforming the sector’s bench- mark that year, but the performance  etween the stocks being variable, ranging from -86.3 per cent (Strata Resources) to +15.4 per cent (Centennial Coal). The second diagram in chart 1 shows a similar outcome for the financials sector  (excluding property trusts). While the variation between stocks was not as marked, there was a similar turnaround from significant outperformance of the sector’s bench- mark in 2007 to underperformance the following year.

These two examples highlight the danger of making investment decisions based on representativeness bias without undertaking proper research and then forming a rational opinion. Looking at past performance  of a particular asset class could also be a form of representativeness. Despite numerous warnings that past performance is not an indicator of future performance, investors often look to this as a guide as to what  to invest in. This approach is a flawed strategy, as shown in chart 2. If you invested in each year’s best asset class over a 20-year period, an initial investment of $10,000 in December 1988 would have been worth  32,374 in December 2008.

This is significantly less than the $50,862 it would have been worth if invested in a typical balanced fund, where the asset allocation is fixed over the whole period. Another heuristic bias which can influence the way people make investment decisions is over-confidence.


When investors make a number of successful stock picks, a certain level of over-confidence can creep in and their desire to trade more increases. Investors don’t necessarily weigh up the cost of trading against  the marginal benefit of holding one stock rather than another, since they are so confident the new stock will be an imminent success. While this may or may not lead to higher gross returns, the increased trading  activity generates higher trading costs (brokerage) and hence may result in lower net returns than a “buy and hold” approach. For Australian investors there are also tax implications for stocks held for less than  12 months. The link between over-trading and reduced net returns was explored by Brad M Barber and Terrance Ode- an. Their analysis, which was based on around 66,000 households in the US with accounts  at a large discount broker from February 1991 to January 1997, showed that over-trading had a huge impact on net returns.

There can also be a level of over-confidence in one’s investment prowess, particularly with regards to forecasting ability. This can lead to bad stock decisions. Studies have also shown that investors who are  excessively over-confident don’t diversify their portfolios adequately, don’t believe in the positive risk/return trade-off (that is, higher risk means higher returns) and tend to take on more risk. This tendency for  ver-confidence highlights the need to have a long-term focus so as to minimise trading activity. It also highlights the benefit of investing in managed funds, where trading costs are shared across a pool of

Heuristic biases are thus ever- present, often clouding investors’ decisions. One way of reducing investors’ susceptibility to many of these biases is to invest with professional fund managers. Valuation models,  disciplined processes and extensive company visits are just a few of the tools they use to help reduce the emotive element in the decision-making process and determine the true price of a stock or security. Constant peer review by fellow team members and oversight by an investment committee also help to reduce biases and improve the probability of decisions being based on logical and rational analysis.

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