While it's often said that investor behaviour is the single biggest determinant of investment success, managing the emotional triggers can be challenging.

The good news is that for those who can identify emotional biases and overreactions in their own behaviour and in the market at large, there are ways to avoid moves that sabotage returns and add value to portfolios. Understanding the impact of emotional and irrational behaviour, and buying or selling mispriced assets at appropriate times, can be a viable investment tool.

"Investors have emotional responses to securities and their issuers, and that is a permanent feature of the market that can be exploited. Emotions can have an effect on the value of securities, and that creates opportunities," says Paul Kaplan, a panellist at a recent forum in Toronto, Canada, and director of research at Morningstar Canada.

"Over time, you realise that a lot of mistakes that investors make are not errors based on factual information – as there's a fairly level playing field when it comes to access to information," says co-panellist David Wong, from another Canadian fund manager, CIBC Asset Management.

emotion behavioural bias investing article

Some securities can elicit an emotional response

He believes many mistakes are based on behavioural aspects such as overconfidence, and can therefore be corrected using behavioural concepts.

According to Morningstar's Kaplan, the "value effect" of behavioural finance is that the prices of companies that are perceived as glamorous can be driven to irrational highs by positive or greedy investors, and unloved companies can be squashed or ignored. Securities can surge in popularity well beyond their worth, then crash when the mood changes.

"Investors can be drawn to particular securities simply because the companies that issue them elicit an emotional response.

"What investors are doing in these situations is short-cutting the analysis, and just deciding that they like certain companies, or the opposite, that they don't like them," Kaplan says.
Investors are particularly vulnerable to "recency bias," says Craig Basinger, a CIO with GMP Asset Management. This means they assume a particular stock or even the overall market will continue to display recent positive or negative price momentum.

"Stocks with a high number of buy ratings tend to underperform those with fewer. With highly recommended companies, the good news is already out there, and is reflected in the price.

If you look at unloved companies with no buy rating, once they are upgraded from a sell or a hold there can be a reversion to the mean and the stock performs well," Basinger says.

He believes it is problematic that many investors are more comfortable buying a stock with 10 buy recommendations than one with three. "There is safety in following the herd and sticking with consensus. But the best returns in the market are not made by people who stick with the herd."

He sees investor behaviour as a key cause for mispricing among investable assets. "Emotions get the better of people. If you realise how the market is impacted by these behaviours, you can make money off those emotional mistakes."

CIBC's Wong says it's important to be aware that senior executives within a company may have their own biases as well, and is wary of the impact of a rosy forecast or persuasive personality when doing his investment research.

Morningstar research consistently shows the individual returns of retail fund investors, on average, have underperformed the long-term returns of the funds they own, due to poor timing decisions on purchases and sales.

"Fear manifests in a practical way on Main Street. People 'buy high' due to a fear of missing out, and 'sell low' due to fear of loss, and their individual investment returns are typically lower than the long-term returns of the funds," Wong says, with this behaviour applying equally to equities, fixed income and managed funds.

Kaplan also emphasises the role financial advice can play in helping investors recognise their own own impulses and thereby improve outcomes, particularly through risk tolerance assessments.

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Jade Hemeon is a Toronto-based freelance financial journalist and Morningstar contributor. 

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