Investment Choice – Preferring securities in your portfolio over alternative investments, e.g. if you prefer Standard Bank you will buy Standard Bank, not ABSA because it is also a bank.

Risk Aversion – If you have the choice between portfolios with the same expected return, a rational investor will take the one with the lowest risk.

Rational Expectations – Incorporating all available information in an unbiased and coherent fashion. An example of this is that some investors expect 20% pa from equity markets going forward, but all evidence suggests this is way too high.

Unfortunately the rational investor has been missing for a while. Some of the irrational behaviours to which investors can fall victim are overconfidence, loss aversion, anchoring, and herd behaviour.

Overconfidence
Overconfident investors/traders tend to believe they are better than others at choosing the best stocks and best times to buy or sell. Studies have shown that overconfidence leads to overtrading.

Overtrading normally leads to the investor selling losers at low prices and buying winners at high prices. Investors tend to buy recent winners, even if they are by then significant overpriced. The increase in trading also leads to an increase in trading cost and taxes liabilities; this reduces the yield of the investor.

Loss Aversion
Loss aversion is part of being a rational investor, but taking this to the extreme can negatively affect an investor’s prospects. An example of this was in the credit crisis, where investors sold all of their shares after the markets crashed. They therefore locked in the losses they suffered because they didn’t give the markets time to bounce back.

Anchoring
Investors tend to anchor the price of a share on past experiences. An example is when a share drops significantly investors will buy the share believing that the price will rebound to historic levels without doing research to see if the drop in price is due to fundamental changes in the company.

Herd Behaviour
One of the most infamous financial events in recent memory would be the bursting of the internet bubble. Herd behaviour happens due to two main reasons:

The rationale that, “everybody is doing this and not all of them can be wrong so this should be correct.”

Being a rational investor is extremely difficult. Investors should only invest with available information and without being biased by emotions. It is therefore imperative to have a solid process and to do research on the company or fund that you invest into.

Kind regards,

Gerbrandt Kruger

info@seedinvestments.co.za
www.seedinvestments.co.za
(021) 914 4966