SETTING REALISTIC INVESTMENT OBJECTIVES

Do you sometimes feel like you didn’t get what you expected from your investments while normal ups and downs of the market can cause emotional reactions, the question that we need to ask is, do we have realistic expectations? Experts in the world of behavioural finance would suggest we probably don’t. Here’s why.

Scientists and economists understand more all the time about the behaviours that impact the way we all act and react to investing. They believe that we all have the same biases that cause us to set high expectations which inevitably result in disappointment. What are the biases? They are what psychologists call systemic or judgmental “errors” that guide behaviour and make people susceptible to surprise or disappointment. Three specific biases affecting investor behaviour include:

• Over-optimisim
• Hindsight
• Faulty intuition

Over-Optimism

“The investor’s chief problem – and even his worst enemy – is likely to be himself”. Benjamin Graham – The Intelligent Investor.

Over-optimism is a very common and powerful bias. Most people are optimistic to some degree. However, when it comes to accurately estimating our own abilities or predicting the future, optimism is often a cause of error. It tends to cause us to underestimate the likelihood of a negative outcome. This leaves us vulnerable to “statistical surprises” in investments and we may over-react as a result. Think about what typically happens when businesses report earnings. One way to control investment over-optimism is to make sure you always make yourself aware of both the upside and downside potential. Positive earnings surprises for highly favoured businesses have a very small positive effect on stock prices, while negative surprises have a much larger negative effect. Further demonstrating general investor over-optimism in predicting the future, positive surprises merely confirm expectations, while a negative surprise damages expectations and instills doubt.

Hindsight

“I always new it was true.” We all tend to believe that events that have taken place were predictable . We also think events that did not happen were unlikely. Hindsight bias is particularly rampant in the financial media. Even though the best experts did not predict an event, the event seems to have been inevitable immediately after it occurs. Think about this next time you hear a business report on the news. The activity of the stock market is reported as if it were expected to happen. The hindsight bias tends to bolster over-confidence and makes us think the world is more predictable than it really is. Hindsight encourages us to assess the likelihood of an outcome based on the facts of the specific case rather than assessing the likelihood based on a broad class of similar situations.

Faulty Intuition

Look at the series of possible outcomes resulting from a fair coin being tossed six times. Which outcome do you think is more likely?

Outcome #1 Heads, Heads, Heads, Tails, Tails, Tails
Outcome #2 Tails, Heads, Heads, Tails, Tails, Heads

Both outcomes are equally likely but if you are like most people you may have thought that the first pattern, three heads followed by three tails, is more rare and less likely to occur than the second. This is because you are attempting to find a repeating pattern in the first series, even though there is no real reason to believe that one exists. Searching for a pattern is so common in stock market analysis that it is taken for granted. Market analysts, in particular, are notorious for projecting past trends too far into the future. They project sales, earnings, prices and many other statistics years or decades into the future, notwithstanding the fact that these quantities are difficult to predict and may be inherently unpredictable.

Extrapolation on Elvis

Some years ago a wise market watcher in the U.S., Stephen Leuthold warned against extrapolating past trends too far into the future. At the time, Leuthold wrote: “In 1960 there were 216 Elvis impersonators, by unofficial count. In 1970 there were 2400. By 1980 there were an estimated 6300 Elvis impersonators and assuming the continuation of the trend, by 1992 this number should reach 14,000. By the year 2010, one in four people will be Elvis impersonators.”

DEVELOPING REALISTIC EXPECTATIONS

Fortunately experts tell us that, with some effort, we can overcome some of these natural human biases. How do we do this?

• Use Your Financial Advisor. Financial advising is a prescriptive activity whose main objective is to guide you to make decisions that best serve your interests.
• Develop a Policy and a Process. Create a policy and a process that helps pre-establish decision making rules in an attempt to avoid succumbing to tempting biases. For example, before you invest in something, identify when you are going to sell it.
• Practice. Work with your financial advisor to set and track expectations, review regularly.

Written by Brandes Investment Partners & Co.

This article was prepared by Terry Fay who is an Investment Advisor with Dundee Securities Corporation, a DundeeWealth Inc. Company. This is not an official publication of Dundee Securities and the author is not a Dundee Securities analyst*. The views (including any recommendations) expressed in this article are those of the author alone, and they have not been approved by, and are not necessary those of Dundee Securities.

The particulars contained herein were obtained from sources which we believe reliable but are not guaranteed by us and may be incomplete. The opinions expressed have not been approved by and are not those of DundeeWealth Inc., its subsidiaries, or its affiliates, including, but not limited to Dundee Securities Corporation, Dundee Private Investors Inc. / Ltd., Dundee Insurance Agency Ltd., Dundee Bank of Canada and Dundee Mortgage Services. This website is not deemed to be used as a solicitation in a jurisdiction where this Dundee representative is not registered.

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