Do we really make rational investment decisions?

Remember that time when a friend gave you that hot stock pick, which went on a downward spiral as soon as you purchased it.  But you refused to sell hoping it would come back so you can save face. “It is only a paper loss anyway, it will come back”, you kept telling yourself.  Remember that time when you bought a few shares of a stock with the intention to gradually buy more.
Unfortunately the price went up a little bit, so you decided to wait for the price to pull back. Instead the stock continues to climb and you never buy more shares, ultimately losing out on the gains. These not so rational behaviours are two of the many concepts identified by behavioural analysts as contributors to irrational decision making. An evolving and still controversial field known as “behavioural finance” attempts to explain how emotions influence investors in the decision making process.

Holding on to a losing stock too long is actually a symptom of loss aversion. Research has shown that we tend to feel the pain of loss more strongly than the pleasure of a gain. Therefore investors are more likely to sell stocks that have increased in value and hold on to declining stocks, delaying the inevitable pain of losing. This strategy ultimately leads to a portfolio consisting of losing stocks only.

Another common mistake is anchoring. An example of this would be refusing to buy a stock today because it was cheaper six months ago or refusing to sell a stock because the price was higher six months ago. If stock A was priced at $100 last year and the company lost market share, reducing the stock price to $60 per share, we have a tendency to hold on to that $100 reference point as the true value of the stock. Therefore we won’t sell the stock believing that the stock is undervalued and should return to $100 share price. Although markets can be volatile, in this scenario the price decline was the result of a change in underlying fundamentals. Human beings have a tendency to mentally anchor to the most recent movements in markets. A study showed that mutual fund investors under perform when flocking out of a badly performing mutual fund into a well performing mutual fund. A fund that performed well will take in new deposits and won’t perform as well going forward. On the contrary, a fund which did not perform as well will receive a number of redemptions and will usually perform better going forward.
Essentially the investor is buying high and selling low and ends up earning a return lower than the better  performing  fund . Anchoring also leads investors to believe that the most recent event will continue in the future.  As Warren Buffet eloquently put it: “People tend to underestimate low probability events when they haven’t happened recently, and overestimate them when they have.”
Another very common mistake exhibited by investors is mental accounting. Individuals create separate accounts in their mind for their money. Mental accounting can be put to good use if you want to save for retirement or a down payment on a house. However, it can also be harmful if you don’t consider all your accounts as part of your total wealth. It doesn’t make sense to hold money earmarked for a vacation in a savings account earning less than a ¼ per cent while carrying a credit card balance with an 18 per cent APR. Although it would be logical to pay off the credit card debt, we made the decision in our mind a while back that we would not touch the vacation account no matter what.  
Traditional financial theory is based on the premise that markets are efficient and that individuals behave rationally, but do they really? As some of the examples illustrated investors do not always make logical decisions. Perhaps we have all been guilty of making some of these mistakes and this is an attempt to remind us all to be aware of emotional biases when making investment decisions.  

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited.  The Bank accepts no liability for errors or actions taken on the basis of this information.