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Round numbers and cognitive bias

03 July 2014  |  Investing

NumbersInvesting in shares is supposed to be a rational process. But human beings are only partially rational. So it is not suprirsing that many of our decisions are biased. One of those biases, pointed out in today's AFR, is that we are fascinated by round numbers -- the score. Will the All Ords get back to 6,000? Will the S&P500 hit the 2,000 benchmark?

Investing is not supposed to be a game with scores, but because it involves numbers then it is hard not to see it that way. And because we see it that way, then to some extent it can become true.

It is part of what is termed cognitive bias: our tendency to see patterns in things when none probably exist. Another bias, much more dangerous, is the tendency to sell low and buy high. Hanging on through tough times is difficult, as the AFR points out:

"As Glassman himself wrote in early 2011, what he got wrong was that while historical averages show that stocks offer a decent return if you can hang on through the tough times, the bottom line is “most investors find that excruciatingly difficult to do”.

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Stocks bounce along from year to year and investors react to that.

He got so sick of telling investors to just hang on that in February 2011, when the Dow was 12,130, he changed tack and told everyone to be more cautious, the opposite of his original strategy. The world had changed he said, it was a riskier place, the US economy wasn’t going to grow at anything like the pace it had, house prices had slumped, there was terrorism to worry about and investors had to be aware of “uncertainties”, as the famous University of Chicago economist Frank Knight named them.

Writing for The Wall Street Journal, Glassman said he could be wrong about the world being a riskier place.

“But even if I am, this is still a time for investors to proceed with caution. They can protect themselves against the worst by ratcheting down the proportion of stocks they own compared with bonds, and by buying hedges such as ‘bear funds’, whose prices go up if the market goes down.”

Using this strategy, investors pay an insurance premium that slightly trims any upside but takes a fair chunk of any downside out of the equation.

He thought his new strategy sat well with the new risks he outlined and also talked to the psychology of investors. He then quoted Ronald Reagan, who once said an economist was someone who watched something work in practice and “wondered if it would work in theory”.

In reality, it is not a game of achieving benchmarks. The game never ends, and scores can actually go backwards. What investors have to be prepared for is the inevitable volatility in share prices. And long periods of arid returns.

The markets are driven by human behaviour, and human behaviour has inevitable patterns. Look at the line over the long term, however, and the pattern is fairly clear. The markets take two steps forward and one step back on a  regular basis:

 

One clear implication for SMSFs is that risk taking is far more acceptable when you are young. For those who will have to wait for returns, the longer term with shares looks a strong option.

 


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