Blue-chip investors experience cognitive biases


Blue-chip investors are susceptible to cognitive biases that keep the big-cap stocks front of mind – even when the little guys show more promise writes Vanessa Desloires.

In her Smartinvestor article of 09 September 2015 in The Australian Financial Review, Ms Desloires* says “Everyone has held a stock they just can’t bring themselves to … let go of, even though logic screams to sell it. Investors holding on to the hallowed banking stocks have lost about 20 per cent since April (2015). The good news? It’s normal human behaviour. The bad news? It is costing you money.”

Ms Desloires conducted market research into the follies of blue-chip investors by consulting a range of financial advisers in the marketplace. First, she consulted Michael McCarthy who is the chief market strategist of CMC Markets. Mr McCarthy said that “People fall in love with an investment. It doesn’t become a matter of quantitative analysis. It’s a matter of having found a friend and sticking with it for life. It’s a silly thing to do with a share.”

Ms Desloires writes that psychologists have been studying investor behaviour for decades.  She listed as one of her sources, the 2002 Nobel Prize winner for economics Daniel Kahneman who argued against the commonly-held assumption that rationality is the basis for financial decision making.

Ms Desloires next consultant on the matter was Simon Russell, the founder of Behavioural Finance Australia. Mr Russell says that analysis of thousands of broker reports showed the same trend. In essence, people will hold on to falling stocks and sell rising stocks.

According to Ms Desloires, the market momentum suggests they should do otherwise (because) falling stocks continue to fall, and vice versa: rising stocks continue to rise.

Even Mr Russell suggested that: “We are actually doing the complete opposite of what we should do.”

Ms Desloires writes that there is a term for this (counter-intuitive) behaviour: the ‘disposition effect’. But she says it’s not the only reason people do the opposite of what they should. In reading into Professor Kahneman’s analysis, she says the Kahneman ‘prospect theory’ found that people make decisions based on the value of individual losses and gains rather than the goal.

Mr Russell’s comments add to this understanding of psychology by pointing to another behaviour known at the ‘endowment effect’ which describes how people will assign more value to things purely because they own them.

Ms Desloires writes that “In essence, the shares they hold are more valuable than those they don’t, even if they present better value. Investors are susceptible to the familiarity effect, where they value stocks simply because they are familiar with them.”

Simon Russell also points to another psychological effect from familiarity: “Investors are substantially biased towards companies in their own countries. Every country has this effect, it is not explained by tax effects or transaction costs.”

Ms Desloires suggests Mr Russell observed that in the United States of America, “…investors have been observed buying shares in companies that operate from their own state.”

Another of Ms Desloires’ consultants, Christian Ryan of Beulah Capital says the media coverage they receive perpetuates the myth of blue chip stocks. She says that Ryan noted that Australia’s relatively limited market is dominated by very few players. “There is a sense that if you don’t own these stocks, you’re missing out.”

Ms Desloires commented that even “…if investors understand the problem, and know there’s better out there, it can be still hard to part with our friends.”

She says Trading Psychology founder Mandi Pour Rafsendjani comments that the most successful investors use the ‘Three-S’ system: strategy, skill and self-mastery’.

Apparently skill is required to execute strategies: “That is why many great analysts are bad investors. While they may know how to read the markets, they don’t necessarily have the skill to execute that strategy”, Ms Pour Rafsendjani says. “Key to investor failure is the lack of self-mastery, or mastering your emotions and staying true to your strategy against all odds.”

Ms Pour Rafsendjani suggests that when a stock’s performance varies from a predicted path, investors exhibit ‘confirmation bias’, which is looking for any clues that might indicate a stock is due to rise in value. “Every little retracement gives you hope again and every time it fails, you get disappointed and deflated,” she says.

According to Ms Desloires’ article, Ms Pour Rafsendjani has a raft of reasons on why investors can’t fail to be human. As Ms Pour Rafsendjani says, the next reason is ‘anchoring’ where a certain profit achieved from holding a stock becomes the new benchmark. Any fall from that height is viewed as a loss, rather than looking at the overall profit picture. She suggests this occurs “…even though they might have to work for two months to make that kind of income from their normal job…”

She suggests it can also be painful to take a loss. Ms Pour Rafsendjani says “Making a profit feels good and having to give back something that made you feel good is painful.”

For example, Ms Desloires says Christian Ryan sees a lot clients who have inherited portfolios from their parents or grandparents and are reluctant to sell because of the perceived connection to their loved ones.

The most effective way of managing ‘familiarity bias’ is to slowly reduce holdings in a company and start gradually introducing new stocks of another company. Regularly reviewing assets is the beginning of the anti-familiarity bias program.

Uploaded 09 November 2015 with acknowledgments.

* Vanessa Desloires (2015) “Know when to fold ‘em”, Smartinvestor, The Australian Financial Review,, Wednesday 9 September 2015, pp. 23-24.