Basic human emotions are the overwhelming drivers of investor behaviour. Craig Hobart looks into why.

In the last edition of Professional Planner we started to delve into the wonders of behavioural finance theory, focusing specifically on the role that investor psychology, emotions and confidence can play in investment decisions and in turn their influence in driving market returns. Two well-documented theories relating to investor behaviour are heuristic biases and frame dependence. In the last issue we looked at heuristic biases, focusing on two in particular – representativeness and over-confidence.

To recap, heuristics are essentially “rules of thumb” gained from previous experiences, which create a natural bias based on that experience rather than on logic. Representativeness bias occurs when investors make decisions based on pre-conceived ideas or stereotypes; while over-confidence can lead to over-trading, poor investment decisions and ultimately lower net returns. In this edition of Professional Planner, we look at frame dependence and its role in explaining irrational investor behaviour. This concept centres on people having “frames of reference” when making decisions – particularly when it involves risk or uncertainty. Essentially, these frames of reference centre on an investor’s ultimate fear of incurring losses – and this fear can play a powerful role in influencing investor decisions.

Frame dependence

An easy way to think of frames of reference is to picture several boxes or compartments in your mind for different pots of money – and when it comes to making a decision, the outcome depends on which pot of money is being invested. Let’s look at an example of frame dependence. Assume a punter bets $10 in poker and wins $50. In their mind, the $10 is the amount that goes in the “can’t lose box” and hence goes back in the pocket, while the $40 goes in the “can lose box” and stays in the hand. After all, the punter didn’t have the $40 at the beginning of the night (and hence sees it as “free” money) and is happy to take high levels of risk with that money. By allocating the $50 between two pots in their mind, the investor fails to make logical decisions.

In this example, the punter should look at their total money as if it is in one pot ($50) and decide how much they wish to risk. This action is likely to result in the punter making more conservative decisions. This behaviour can apply equally to investing. Investors often focus on the initial capital outlay as the amount “at risk”, rather than the accumulated value over time. For example, assume an initial investment of $10,000 that in one year rises in value by $1000. Investors will tend to regard the amount of money at risk as being the initial $10,000, but really the total “at risk” money is $11,000. It is this total amount invested that the investor should be constantly re-evaluating when making investment decisions – whether it is to invest more, redeem or switch to another fund/asset class.

Regret – afraid to make the wrong decision

Another area that falls under frame dependence is regret. The key underlying premise for this behaviour is an investor’s fear of incurring losses. Studies by Daniel Kahneman and Amos Tversky have shown that investors feel a loss two-and-ahalf times more strongly than a gain of the same amount. They call this phenomenon “loss aversion”. This fear of making the wrong decision often means investors don’t assess risk correctly – they tend to over-emphasise risk, which can actually lead to wrong decisions or inertia in making a decision. Investors need to ask themselves which risk is greater: the risk of making a decision that could lose them money; or the risk of missing out on an opportunity that could make them money? Studies have shown that people tend to have the highest level of regret for actions they didn’t take rather than actions they did take. Even Nobel Prize winner Harry Markowitz, one of the founders of modern portfolio theory, which espoused the merits of diversification, suffered from the fear of regret.

He invested his entire retirement money in an even split between equities and bonds, which goes completely against his own investment theories. Why? He didn’t want to regret his decision by diversifying any further. “My intention was to minimise my future regret”. A different example of regret is investors’ difficulty in selling a losing stock. The feeling of regret is strongest when the loss is crystallised – until that point, the investor holds out hope of the stock returning to its “former glory” and avoids generating feelings of regret by holding onto it. Another aspect to this is that if the investor made the original investment decision by themselves, the feeling of regret is much greater than if they were following someone’s advice. It’s not so much about the pain of making a loss, but rather the pain of being responsible for making the decision.

This could explain why investors sometimes find it easier to outsource their investment decisions (that is, to a financial adviser) – apart from needing professional advice, it also means some of the burden of making decisions is shared. By contrast, professional fund managers acknowledge and seek to control this behavioural risk. This is largely through their disciplined processes that allow them to assess the relative merits of investing in particular stocks and make relatively unbiased decisions – if selling a losing stock is the right decision, the framework will be in place to allow that to occur. They constantly assess the risk/return tradeoff of holding one stock versus another stock. Let’s look at an example. An investor is holding a stock which they paid $10 for and it’s now trading at $7. They find it very hard to sell the stock and incur a $3 loss. A fund manager, on the other hand, would look at other stock opportunities and if another stock, identified through their investment process, could offer a forecast gain higher than the original stock, they would have no hesitation in selling the losing stock and buying the other one (after taking into account tax implications and transaction costs).

The fear of regret often leads to inertia in making decisions. In some respects this could be one of the reasons why around 80 per cent of Australians have remained in the “default” fund in their superannuation plan, despite encouragement from the heavily publicised “Super Choice” campaigns. As the default option tends to be a balanced fund, this can mean a significantly lower superannuation payout on retirement than if invested in a higher growth option over an individual’s full working life. Not making a choice therefore potentially exposes investors to greater risk – they are swapping the risk of losing money with the risk of not having enough money in retirement. Given many super investors have a very long time horizon, the latter risk is likely to be significantly higher than the former. Let’s look at an example of how costly an inappropriate investment strategy could be by comparing the outcome of investing in a balanced fund (with a 50:50 weighting in growth and defensive assets) versus a high growth option (with a 85:15 weighting in growth and defensive assets) over a particular investor’s working life of, say, 40 years.


• The investor earns an annual salary of $80,000 for their entire career.

• Their salary increases at an annual rate of 2.5 per cent per annum in line with inflation and is adjusted monthly.

• The investor invests their compulsory 9 per cent Superannuation Guarantee levy payment (net of contributions tax) each month into a balanced fund (comprising 20 per cent Australian equities, 20 per cent international equities, 10 per cent listed property trusts, 20 per cent Australian fixed interest, 20 per cent international fixed interest and 10 per cent cash) over the 40-year period with the first investment starting on July 1, 2009.

• Performance is based on projected longterm asset class returns (using the Capital Asset Pricing Model framework, whereby a risk premium for the asset class is added to a risk-free return) for a 40-year period.

By June 30, 2049, by adopting this strategy the investor accumulates a total sum of close to $2.1 million in the balanced superannuation option (as shown in chart 1). If, however, the investor had made the same investment into a high growth option (comprising 40 per cent Australian equities, 30 per cent international equities, 15 per cent listed property trusts, 10 per cent Australian fixed interest and 5 per cent cash) over the same period, they would have accumulated a considerably higher amount of around $2.5 million – that’s a difference of nearly 20 per cent. That amount would have a significant impact on the investor’s lifestyle in retirement.

While this example does not include the impact of tax (apart from contributions tax) or fees, it does provide a simple illustration of the difference an investment strategy can make over the long term. These articles have highlighted just a sample of investor behaviours that can influence investor decisions and ultimately asset prices – and they are by no means exhaustive. Emotion and the human psyche are indeed powerful forces, often leading investors to make irrational decisions, or sometimes even worse, not making any decisions – both of which can be detrimental to the long-term performance of an investor’s portfolio.

The recent turmoil in the global financial markets has highlighted two of the most extreme emotions – that of greed (associated with good times, optimism and hope) followed by fear (reflective of uncertainty and pessimism) – with ironically the former playing a role in causing the latter. By removing these emotions and psychological behaviours (in the form of heuristic biases and frame dependence) from the decision-making process, investors are in a better position to make logical and rational decisions. Seeking professional investment advice from a financial adviser, taking a long-term view, constructing portfolios based on an investor’s risk/ return profile and investing with professional fund managers are steps an investor can take to help them achieve this.

Join the discussion