The investment games people play
Let’s say you’re playing a game in which everyone has been given $20. In each round, you choose whether or not to put in $1, and a coin is then tossed. If it’s heads, you get back $2.50. If it’s tails, you lose your $1.
How often would you put in a dollar?
The rational response is to play every time. There’s a 50:50 chance you will gain more than you lose.
But in a research project in which the game was played, “Even professional investors didn’t play every time,” says Dr Jack Gray. “If they had a succession of losses they felt they couldn’t afford to keep playing. Or if they had a long run of success they felt they were due for a loss, even though it’s random.”
However, the project also included people with brain damage that reduced their fearfulness. They played the game more often, and ended up 13 per cent wealthier.
That shows the role emotions can play in investing.
Gray, an Australian who works for global investment management firm GMO, spoke at a recent seminar about several ways in which emotions affect investing:
Emphasis on the short term.
A teacher of hugely successful share investor Warren Buffett said the short-term share market is a voting machine, driven by emotions. The long-term market is a weighing machine, driven by fundamentals, says Gray. “In the longer term, fundamentals drive shares back to fair value.”
However, as behavioural finance expert Daniel Kahneman has said, “The long term is not where life is lived. Utility cannot be divorced from emotion.”
In an effort to encourage long-term investing, John Bogle, founder of US index fund company Vanguard, has suggested that shareholders who hold shares for more than three years should get higher dividends, says Gray. “In France, if you hold stock for more than two years you get extra voting rights.”
He says that forecasting over the short term is harder than over the longer term. “We only do a seven-year forecast. We don’t do a one-year forecast. If someone asks for one, our answer is, ‘Pick a number’.
“They say information is flowing more quickly now, but it’s not information, it’s drivel that’s flowing more quickly.
Gray concludes, “Excessive short-termism is a sin.”
The tendency to trade often.
From 1983 to 2003, the average return on US shares was 13 per cent, which is twice the normal rate historically. For the average share fund, however, it was 10.1 per cent, because of transaction costs, fees and so on.
“And for the average investor it was 6.3 per cent — about half the market, because the investors were churning too.”
American share fund investors tend to say, “We’ve tried corn flakes, this year let’s try rice bubbles. The brokers and fund managers are getting rich out of it. But where are the customers’ yachts?,” asks Gray, adding that the last sentence is the title of an academic paper on this issue.
Following the herd.
Fund managers, like individual investors, often find it difficult to invest in what everyone else is investing in.
Gray quotes economist John Maynard Keynes as saying, “The greatest risk in the industry is being wrong and alone.”
The need for comfort.
“You should always be uncomfortable with investment strategies because markets are uncertain,” says Gray. “We have a deep need for certainty, and it’s the one thing markets don’t give.
A final comment from Gray about the irrationality of the share market: “It’s the only market I know where buyers are excited by high prices.”
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Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.