This week I share a short (but hopefully valuable) piece to raise awareness of something that impacts us all and how we make decisions, and often without us even being aware of it!
What Are Biases?
If you were shown a photo of 2 different people, based on their appearance, dress, facial expression, ethnicity, and any number of other visuals, we would have our own 'impression' of that person. In essence, though we might not like to admit it, we have made a judgement about that person based on what we see, but more significantly, based on our biases.
Biases, which we all possess by the way, can cause us to be unintentionally prejudicial, and are formed over decades of experiences, beliefs, perceptions, information and thought. Our biases can have a positive, negative or neutral impact on our experiences and decisions.
What Is Cognitive Bias?
Cognitive Bias is often described as a systematic error in our way of making decisions and judgments. It from these errors that the world of Behavioural Finance has mushroomed. Behavioural Finance is big business globally, many make their living from studying and subsequently working in the finance world sharing their insights about how us humans make decisions about money and how we behave when it comes to money. We interviewed Dr. Daniel Crosby a while back who has studied this extensively and might be worth listening to here if you haven't got to it yet!
Oh, if you are into this type of thing then I highly recommend reading Daniel Kahneman's book 'Thinking, Fast And Slow', which shares this psychology professors vast research and insight on how our brains work....it is a somewhat heavy read but full of incredible insights into how we think! Basically, we all possess these things called heuristics which I'll very loosely define as 'shortcuts' in our brains that allow us to make decisions quickly and to move on. There are lots of things going on in our brains at any one time, so the ability to take these short-cuts allows us to function, but at the same time results in us doing things which are not in our own best interests quite often!
Imagine you were selling a product for €200, and you had the option to offer if either €198,99 or €199.22, which would you reckon would appeal to more people!? In research psychologists have tested how the manner in which a price is presented impacts on how consumers perceive it. Quite interestingly they have found that prices ending in smaller numbers are perceived by us consumers are being more attractive, all due to a little thing called the 'recency illusion'! The fact that the two prices you were offered only differ by 23 cent, and that the latter is actually larger, more consumers will perceive the latter to be a small number/price than the former, purely on the basis that it ENDS in a smaller number, 2 as opposed to 9! Say hello to our own 'recency bias', what is most recent is most impactful, memorable and significant in how we perceive and think about something.
So now that we are finally arrived at the crux of the issue (sorry it took so long) I will try share a handful of ideas that might help in your decision-making as you begin or indeed continue your investment journey.
Recent Performance & Our Biases
When it comes to us deciding whether to invest in something our bias encourages us to consider recency, and make a decision based on that. We see it all the time, and I'm sure most of us would acknowledge that the recent performance of something plays a huge role in our analysis of whether it is a good thing to invest in or not.
I was born in Feb 1980, when the S&P500 index stood at 115, today it stands at 2,754, it has grown more than I have, annual returns, with dividends reinvested of over 11%. This results in a multiple of 24 of initial investment. Meanwhile the price of the average goods and services have increased by a multiple of only 3-and-a-bit...so equity, in that country at least, has stood a patient investor very well. However, that is a nearly 40 year period, and one in which there has been volatility of significant levels.
Let's look at how a simple Global Stock Index has performed since 2000, and how volatility has impacted our decisions. From September 2000 to Feb 2003 it began a temporary decline, falling in price by 54%, nobody was buying in, thinking it was going to keep falling! It then continued its ascent, increasing in value by 77% till July 2007, at which stage everyone was buying in and thinking it would never have another temporary decline! It then went had another temporary decline from mid-2007 to early 2009, falling in value by 46%, at which point nobody was investing, thinking it would never stop falling! In a moment I will outline how it has done since 2009, it has been significant!
Equity prices and property prices are not for one second closely linked in terms of performance, as you'll see, but let's look at property investing for a moment as this impacts us all as we just love to buy property here in Ireland! According to Central Statistics Office data (link here) house price index in Ireland went from 100 in January 2005 and climbed to a peak of 133 in September 2007 (just when I and thousands of others bought our first home!). We all know what happened next, prices slid from then until Summer 2012, falling from 133 to 55. Recency Bias had a significant impact on people's decisions at both ends of this scale, when prices were climbing our brains can convince us that they will continue doing so for the foreseeable future, everyone was buying. Likewise, when prices were falling for 7 years, people start believing that they will fall forever, nobody was buying (I was fortunate to do so - in an effort to re-balance!). Today they suggest we stand at around the 100 mark, what is your recency bias telling you!?
From April 2009 to April this simple Global Index has increased in value by over 305%. This has been one of the longest and most significant upward runs in equity history. Our recency bias might try and tell us that this level of positive increase will continue for ever, it will not. While I believe that the great companies of the world will continue to grow their profits and deliver more developed products and services to the worlds 7 billion (and growing) people. While I am certainly not in the business making predictions, based on all of history it would is possible but not probable that this level of growth will continue for the long term. A period of significant temporary decline is never far away. The danger here is that with such astonishing recent growth new investors may be tricked by their recency bias that this will continue forever, it will not. They invest now and expect to be up 300% in 10 years, this is unlikely! What is likely that there will be significant temporary declines in the short/medium term. We must expect this temporary and significant declines, we must not be surprised by it, as surprise is the mother of panic, and panic is an investor's worst enemy! It pays to keep our perspective focus on a far broader term than what has happened in recent times only.
Paddy Delaney QFA | RPA | APA | Coach