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Bringing the theory home: Our behavioural biases in a South African context

James has five years’ experience in professional services in South Africa and Europe, following which he joined Anchor in 2019. He completed his master’s in finance in 2014, writing his thesis on behavioural finance in South African equity markets.

My grandmother and I are at war. Despite the abundance of academic-made-palatable behavioural finance findings regarding irrational investor behaviour, coupled with my persistent reminders of those findings to her, she still refuses to acknowledge that she may be at risk of irrational decision making. In her mind, her extensive successful investing experience proves her immunity to such fallibility, and her investments will eventually turn. Call me a pessimist, but the unsustainable bull run of the JSE’s last 30 years coupled with increased complexity faced by investors as a result of globalisation and technological disruption means that the confidence she feels as a result of her past success may be false. For someone so passionate about our behavioural shortcomings as I, it is a frustrating debate.

To be fair, my grandmother is not alone in ignoring the findings of some of the world’s finest minds who ply their trade in the field of behavioural economics; unfortunately, those same behavioural biases which lead to our downfall also prevent us from practically addressing them. Overcoming our flawed foundations is a battle that starts anew every day, first with cognisance and acceptance of our fallibilities, then with an understanding of the potential risks and consequences thereof, and finally with a plan to overcome them. Nobody is immune.

Although my primary aim in writing this article is a strategic play in winning the war against my grandmother, the message is useful, even if just as a reminder, to all investors, young and old. My hope is that showing why we don’t take behavioural finance seriously, coupled with distilling relatable examples to SA investors, will be the message required to break through. My strategy to win this war begins with a brief outline of the rise of behavioural economics and finance. I’ll then talk about four biases which we as SA, yet global, investors are particularly at risk of falling prey to. Finally, I’ll provide some simple advice as to how to begin the process of overcoming them.

The rise of behavioural finance

Behavioural psychology has risen in popularity in the last decade beyond academic curiosity to pop-knowledge, primarily as a result of outstanding consumer publications by pioneering academics like Dan Ariely (Predictably Irrational) and Nobel laureates Daniel Kahneman (Thinking, Fast and Slow) and Richard Thaler (Nudge: Improving Decisions about Health, Wealth, and Happiness). Their work and theories are, however, often dismissed as fun thought experiments, exposing their test subjects’ irrational decision making when faced with clearly logical, yet largely inconsequential, situations. Their work finds people to be systematically irrational as a result of a host of fundamental behavioural biases, people’s comical mistakes not being once-off, but consistently repeated and, in Ariely’s words, “predictable”. When the fun, yet often benign, findings in behavioural psychology are applied to economics (behavioural economics) and our world of financial markets and financial decision making (behavioural finance), the implications of our irrational decision making become considerably more real and consequential.

At a macro level, our biases undermine a foundational assumption of academic economics. Traditional economic models exist in a vacuum underpinned by once considered reasonable assumptions, including that of rational economic participants; the finding that people don’t just make occasional bad decisions, but systematically do so, creates a world of doubt in the applicability of those models. In light of this, it is not surprising that purely academic economics often fails to predict, or even adequately explain in hindsight, the true cause behind financial market volatility, both in irrational booms and crashes.

From the macro to the micro, behavioural finance brings the observations of behavioural psychology’s shortcomings from broad economic reference to the investment world. Behavioural finance shows exactly where we go wrong, attaching names to our investment biases that have become common terms in investment speak. References to loss aversion, overconfidence, mental accounting, anchoring, familiarity and the disposition effect, to name a few, are frequent as if our shortcomings are readily taken seriously, but how much is actually done to limit the damage caused by these biases?

Inherent biases themselves may make you think you are immune to behavioural shortcomings

Despite the conclusive nature of the behavioural finance findings and the damage to investment returns they are directly responsible for causing, very few people can honestly say they have put in place and maintained controls to mitigate the risk of associated loss. To be fair, it is difficult to safeguard against flaws which are complex to quantify and observe in the moment, but this is not necessarily the reason for inaction. More likely the reason is our inherent optimism or overconfidence biases: much like my grandmother, we believe the robust academic findings simply don’t apply to us in isolation.

Perhaps we think we are just above average? Our optimism and overconfidence often lead us to overestimate our personal abilities, best illustrated with the frequently repeated comical finding that more than 80% of people feel they are above average drivers. The vast sample sizes upon which behavioural biases have been tested are sufficient to rule out individual insusceptibility at a very high degree of confidence; you are almost guaranteed to be as endangered as any other investor.

Acknowledging the impact of our overconfidence in concluding whether or not we are personally susceptible to detrimental behavioural biases is the first step in successfully addressing the risk of losses. The next step is taking stock of the potential damage of our biases.

Our behavioural biases in an SA context

Provision of examples regarding the consequences of our behavioural biases in a local context serves to increase the relevance of the largely foreign academic findings to our SA selves. Although the following examples are not necessarily applicable to all SA investors, they bring home what is often seen as a foreign problem to a local context, indicating our need for deliberate management of our behavioural biases.

As Darryl Hannington referenced in his article entitled Invest(ing) in the other 99%, The Navigator, Strategy and Asset Allocation Report 3rd Quarter 2019, the JSE was the best-performing market in the world from 1900 to the end of 2016. Further, even over the period of the GFC, JSE investors were rewarded with a standout compound annual return of 18% over 10 years.

In short, our long-term memory is dominated by an incredible period to be an investor on the JSE. SA has historically been as good an investment destination as any country worldwide, reducing any downside, if not even creating upside, of being overweight in our local market relative to global potential.

The past three years have been significantly more difficult, however, with the JSE returning less than 2.5% compound annual growth with a large portion of that growth attributable to a small handful of stocks. Although it is not unusual for markets to go through periods of underperformance, SA is facing significant challenges; given the macroeconomic and political headwinds being experienced locally with no immediate-term indication of a turnaround, a belief that broad-based local growth will return to the historic mean of global overperformance is a long-shot. While some local companies will continue to thrive and it will without a doubt be possible to generate investment returns, it is going to become increasingly more difficult to achieve world-beating returns purely in our local market. Where the downside of investing with SA market concentration historically was low, the longer-term consequences may be significantly higher.

The logical move, as argued by Darryl, is international diversification. Yet our behavioural biases might persuade us otherwise; based on our historic view and understanding of the JSE, we may well remain disproportionately invested in it in expectation of a return to global outperformance. Four biases may be responsible, cognisance of which may be enough to begin the process of overcoming our personal investment shortcomings.

First, the anchoring bias describes investors’ tendency to hold onto a belief, in this case the consistent outperformance of the JSE, and apply it as a reference point for evaluation of future decisions.

Second, the self-attribution bias describes investors’ tendency to attribute successful outcomes to their own actions, resulting in them potentially attributing their outstanding performance historically in the JSE to their own skill ahead of macro-tailwinds. This in turn may give them an expectation that regardless of the depressed outlook, they as individual investors can still find returns locally.

Third, the gambler’s fallacy occurs when investors see patterns where none exist, in this case the pattern that the JSE always goes up, giving them the expectation that it will revert to that mean in the future, making the JSE the superior international market for investment.

Finally, as mentioned by Darryl, the home bias describes our preference for investments we are familiar with, largely as a result of falling in our own country, further preventing us from investing adequately offshore.

Mere cognisance of the above four biases may be enough to make us adequately pursue an international diversification strategy. Yet even in that case one further behavioural observation potentially stands between us and rationally executing on the proposed strategy: the disposition effect.

The disposition effect describes our tendency, in the event of a liquidity constraint, to sell profit-making investments ahead of loss-making investments. This bias, specifically proven to be in effect among SA investors, may nudge investors to sell their profitable positions ahead of loss-making positions when creating the liquidity to diversify offshore. The disposition effect has been found to be incredibly costly worldwide as historically, profit-making investments have continued to outperform, and loss-making investments have continued to underperform. Taking away the JSE’s historic performers and retaining the dogs will leave investors even more exposed to the downside risks of SA’s economic future.

What can be done to overcome our biases?

The understanding of our biases and the potential cost they may have on our investment returns lays the foundation for protecting ourselves from the downsides thereof. But awareness is far from action; deliberate controls need to be put in place.

The number one, and likely easiest, mitigation control is the consultation of a trusted independent third-party or group thereof regarding your investment decisions. Such people may be a knowledgeable friend, an investment club or a professional investment advisor. Most of our decisions influenced by our behavioural biases are objectively irrational, making it possible for independent advisors to identify poor decision making and question the reason for it. Running the decision by someone trusted by you makes it significantly more likely that you will both be called out on your irrational decisions and that you will act appropriately on their advice.

We are all susceptible to behavioural biases, despite what our inherent overconfidence might tell us, and in a SA context, we are particularly exposed to significant downside risk. To my grandmother, in the absence of trust in her dear grandson, my plea is that she run her investment decisions by an independent investment professional. There is no denying that her historic returns are outstanding, but in an increasingly difficult environment to find returns, relying on the repetition of local past performance is dangerous. She is definitely not alone; we could all do with an independent opinion.



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WEBINAR | The Navigator – Anchor’s Strategy and Asset Allocation, 2Q24

Anchor CEO and Co-CIO Peter Armitage will host the webinar, provide an introduction to current global and local market conditions and give his thoughts on offshore equities. Together with Head of Fixed Income and Co-CIO Nolan Wapenaar, Pete will also discuss Anchor’s strategy and asset allocation for 2Q24, focusing on global equities and bonds. In addition, Fund Manager Liam Hechter will provide insights into local equities, highlighting some investment ideas; Global Equities Analyst James Bennet will discuss Ferrari and give an update on Tesla, and finally, Analyst Thomas Hendricks will participate in a Q&A with Peter, explaining the 10-year US Treasury to attendees.