Key behavioural mistakes made by investors

With some eight million members and close to R2 trillion of assets under management, South Africa’s retirement fund trustees are probably the most influential group of investors in the country ­­– and probably the most fortunate too, as the regulators have provided them with some solid guidelines to avoid the behavioural pitfalls that most investors fall foul of, writes Rob Macdonald.

Let’s examine some of the key behavioural mistakes that investors make, and see how the prudential guidelines laid down for retirement fund trustees address these mistakes.

Investors can be their own worst enemies

As the late Peter Bernstein wrote in his book, “Against the Gods”, the evidence “reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty”. This is the fundamental challenge any investor faces; that at the heart of investing is uncertainty.

Investors try a multitude of techniques to overcome uncertainty, ranging from trying to predict the future on the back of huge amounts of analysis, to comparing the past performance of asset managers and relying on this as a predictor of the future.  And in so doing, make a number of behavioural mistakes which result from either emotional weakness in succumbing to greed or fear, or from cognitive frailties; which they are often less prepared to acknowledge.

Overconfidence might be surprise to investors

In fact, the real danger is that investors are overconfident in areas where they have some knowledge, but research shows that increased levels of confidence do not correlate with greater success. There are a number of studies that show how people are overconfident in a variety of spheres.

The classic example being when dealing with driving ability, where most people rate themselves as better-than-average. One study in the US showed that 82% of people say they are in the top 30% of safe drivers.

Overconfidence often plays itself out when investors are familiar with something, like an asset manager or a share. In the US for example, people will often own the share of the company for which they work in their retirement portfolio because they feel confident about their knowledge of the company, even though it is probably more sensible to diversify one’s exposure away from one’s employer.

This hard lesson was learned by many unfortunate Enron employees, many of whom had up to 50% of their retirement fund invested in Enron shares, which were worthless when the company imploded. So not only did employees lose their jobs, but also significant portions of their pensions.

To overcome the very real risk of overconfident trustees, the regulators have provided a number of guidelines.

• The first is to engage the advice of experts, (Pension Fund Act and Circular PF 130 – Good Governance of Retirement Funds, paragraph 39);
• The second is Regulation 28 of the Pension Fund Act, which outlines the asset class limits for retirement funds.

The best-known guideline in Regulation 28 is that funds should not have exposure to more than 75% in equities. But essentially what this guideline is doing is encouraging trustees to diversify their investments and limiting their exposure to any single asset class or instrument. The maximum, for example, that a fund can hold in a share is 15%, but that is for a company with a market capitalisation of over R20bn. If a company has less than R2bn market cap, the fund can hold a maximum of 5%, and between R2bn and R20bn, a maximum of 10%.

Then there is fear in the form of loss aversion

Amos Tversky, generally acknowledged as the forefather of behavioural finance, said that people feel the pain of loss twice as much as they derive pleasure from an equal gain.  In 2001, a review of the UK retirement fund industry by Lord Myners highlighted that trustees were prone to “reckless conservatism” because they were investing members’ funds in conservative portfolios to avoid any negative returns over quarterly reporting periods.

This approach was feeding the trustees’ loss aversion fear, and more significantly it was resulting in investment strategies that were inappropriate for the long-term investment needs of the members.

A leader in the field of behavioural finance, Meir Statman, sums up this behaviour quite neatly: “(P)eople trade for both cognitive and emotional reasons. They trade because they think they have information when they have nothing but noise, and they trade because trading can bring the joy of pride. Trading brings pride when decisions turn out well, but it brings regret when decisions do not turn out well. Investors try to avoid the pain of regret by avoiding the realisation of losses, employing investment advisors as scapegoats, and avoiding stocks of companies with low reputations”.

The mistake of anchoring

Very often investors will anchor their perceptions or expectations on something that can change, such as the purchase price of a share, or its historical price, or on random information or data.

As an example, the world’s leading investor Warren Buffet says: “When I bought something at X and it went up to X and 1/8th, I sometimes stopped buying, perhaps hoping it would come back down. We’ve missed billions when I’ve gotten anchored. I cost us about $10 billion (by not buying enough Wal-Mart). I set out to buy 100 million shares, pre-split at $23. We bought a little and it moved up a bit and I thought it might come back a bit – who knows? That thumb-sucking, the reluctance to pay a little more cost us a lot.”

The most common way that trustees commit this error is by anchoring their expectations of an asset manager’s performance on the most recent past performance, either good or bad. If good, they expect it to be repeated straight away, if bad, they deem it a reason to fire the manager.

To address the risks of loss aversion and inappropriate anchoring, Annexure B to Circular PF 130 requires trustees to outline their rate of return expectations as well as the anticipated volatility of this rate and the timeframe for the expected returns. Furthermore, it requires trustees to indicate how they will monitor performance against these expectations.

This is a fundamentally sound cornerstone for any investment strategy because it means that trustees will not anchor their expectations on unrealistic outcomes nor make decisions over inappropriate timeframes, despite the very likely shadow of their loss aversion instincts kicking in when markets are volatile, particularly on the downside!

(Rob Macdonald is Head of Consulting and Institutional Business at Nedgroup Investments and former consulting editor of Blue Chip Journal)