Emotion plays a much bigger role investment decisions than most investors would like to admit – and this can have devastating consequences on returns, according to Allan Gray head of retail Chris Inifer.

In July’s Netwealth educational webinar, Inifer looked at five ways our emotions can get in the way of making the right call at the right time. He advocated taking a step back from a short-term, aggressive and circumstantial approach to investments, and considering things more like Star Trek’s unflappable Dr. Spock

“Not that I want to see you at any of those Star Trek conventions they have going in the US,” he added.

99 out of 100 engineers can be wrong

At the outset, Inifer quoted the "father" of value investing, Benjamin Graham, who said: "The investor's chief problem and even his worst enemy is likely to be himself."

Inifer explained that investors typically have the mindset – much as they wouldn't concede to it – that "we do the same thing as everyone else in investment, yet somehow think we're going to get better than average returns." He said investment was somewhat unique in this regard, because if 99 out of 100 engineers tell you to build a bridge in a certain way, "You should probably listen to them. But investment isn't like that. It's probably the complete opposite.

“Listening to the vast majority as it applies to investment invariably leads you to mediocre outcomes. We make decisions based on imprecise impressions, beliefs and shortcuts rather than rational analysis.”

Inifer argued that these investment pitfalls are driven by two competing mindsets: he said that, on the one hand, we have the “X brain,” which is “quick and dirty” and “typically makes decisions based on similarity, familiarity and proximity. We need that part of our brain. We need it to help decide what we're going to put on during the day, where we're going to go, how we’re going to drive our car, how we’re going to get somewhere and what we're going to eat for breakfast.” On the other side, there’s what Inifer called the “C brain,” which he said was “far more deductive and far more logical. The problem is that we can only process information one step at a time. It’s the ‘Spock’ part of our brain.’”

To illustrate, he pointed to Professor Shane Frederick’s Cognitive Reflection Test, which used three simple questions to identify those who were using the proverbial “X brain” too much in their decision-making processes. One of the questions, for example, involved a bat and a ball, which collectively cost $1.10, and the bat cost a dollar more than the ball. “Most people would say the ball cost 10 cents,” he said, “but if the bat costs a dollar more, then the bat must be $1.10, which together would be $1.20. That’s impossible, so the ball has to cost 5 cents and the bat $1.05.”

Weeding out these moments where we intuit our decisions rather than think about them logically, he explained, was just as important to investing as solving Frederick’s test.

Overconfidence

The first roadblock to “C brain” thinking in investments was overconfidence, Inifer said. While overconfidence can manifest in many ways, Inifer said a critical problem was “the illusion of control. People often believe that they have some control of the outcome of the circumstance for variety of reasons. Typically once you've had some early success, if there're lots of choices available to you when the task is familiar to you, we often assume the same outcome.”

The problem with this, he continued, is that it leads to a lack of consideration for a wider range of outcomes: “We don't spend enough time looking at downside risk. How can this thing go wrong? We need to look for the bust that we don't see; the thing that will really whack me out. They're the things you need to spend a lot of time on as it applies to investment. Often the upside takes care of itself.”

He added that being an expert in your field doesn’t prevent this kind of overconfidence from creeping in. Citing GMO co-founder James Montier’s research into 600 analysts during the Global Financial Crisis, Inifer noted that 70% thought they were doing a better-than-average job than their peers, even though just prior to the crisis in 2008, “91% of sell side recommendations were either buys or holds. This is typical of the sell-side broker industry. You only have to look closely. In fact, you don't even need to look that closely.”

Loss aversion

The flipside of overconfidence, Inifer said, was loss aversion – the idea that people general feel failure much more strongly than success. To illustrate, he pointed to a study which involved a game where a participant is given $20 to play a game with 20 rounds. Each round, the player can either bet a dollar or hold it; if the player holds it, the game advances to the next round, and if they bet it, a coin would be tossed - if the coin is tails, they player would get $2.50 for each successful bet.

In this game, the rational option is to bet the dollar for all 20 rounds, since if there's a 50% chance of victory, then the expected value each round is higher ($2.50 times 50%) than if the player holds the dollar ($1). “But even though people absolutely know the odds and know it's a game of chance and luck going into this,” Inifer said, “the overall participation rate dropped to 40% after losing rounds, which means that people can't cope with losing in the short run. We see that all the time in share markets.”

An investment analogue, he continued, would be investors putting all their money into defensive assets after a loss, which would ultimately result in a lower return in the long-term. “Remember,” he said, “you miss 100% of the shots that you don't take. You have to be prepared to lose in investments. As a fund manager, I can tell you that we're only right 60% of the time. That might not be what people want to hear, but it's actually very good odds.”

Recency bias

Part of both overconfidence and loss aversion is what Inifer described as recency bias – in other words, the idea that if something worked well in the past, it would continue to do so in the future. “For example,” he said, “bond markets performed well. Then we presumed that that would be where we should invest in the future. We see equity markets perform poorly, and we presume they will perform poorly in the future, so we run for over and invest elsewhere.”

Explaining it further, he pointed to the performance of fixed income over a 100-year horizon. “We do take very, very long run perspective on things at Allan Gray,” he said. “You can see that over 100-odd years, fixed income has given you a return of about 3% real. But there are very long periods of time where these asset classes can give you absolutely nothing, or quite a good return

“So if you’re looking at them on first glance, people can talk about them in a defensive way, but depending on the time you buy and sell them, it can cost you a lot of money. So if you’re basing your decisions on the most recent performance of an asset class, that can put you in trouble.”

Confirmation bias

Basing predictions of future performance on preconceived ideas about particular asset classes (and sub-classes) ties into confirmation bias, which was Inifer’s next point. Confirmation bias is the idea that an investor will hold a particular viewpoint and ignore any information that contradicts their beliefs. “We don't like changing our minds,” he argued. “We really don't like it when other people have a different view to ourselves. But we should embrace those differing views, particularly as it applies to investment.”

Elaborating, he created two hypotheticals: company A, he said, was trading at a price higher than the investor actually believes it's worth. "All the brokers love it," he said, "there's lots of positive media coverage, all your friends are talking about it - they're making a profit and they're buying more. It largely is actually priced properly, but you don't want to listen to that story."  Company B, on the other hand, is in a sector facing a cyclical downturn, it's "one of the most hated companies in the share market" and friends and family are dealing with losses and selling their stake.

"Bear in mind, though," he continued, "that in cases like this, a company's outlook only has to go from looking horrific to awful for you to make a good return. Conversely, sometimes a 'Company A' only has to go from looking extraordinary to wonderful for you to lose money.

“So in the former case, whilst it will make you feel really good that you own this company because you'd be in there with all the other people, unfortunately, the risk to you is potentially quite great. Whereas in the latter case, the risks you make will be quite a lot less. It doesn't mean that you don't do your homework, or that you don't do extensive work in research and coverage on what this company does and what the outlook for the sector is. But if you're patient, you might well make an enormous amount of money off the back of that company from not having to spend as much, and you might lose a lot of money on company A."

Self-interest

Finally, Inifer discussed the problem of “self-interest” in investing. Explaining the problem, he asked, "Would you prefer an 80% chance of a double bonus and a 20% chance of getting fired, or just have a guaranteed average bonus? The majority of people would choose option B in that instance, but in investment, that can lead fundamental managers to make non-fundamental decisions."

Specifically, he noted how the five largest Australian fund managers are overwhelmingly weighted towards the top 10 stocks on the ASX. "Because the majority of people's money is in these managers, 'I can't afford to blow things up' is the primary mindset. It's managing money at or about the index weightings so you don't disappoint anyone too much. And by not disappointing anyone too much, you keep the money, charge an active fee - even though you hover close to the index - stay in business for a long time, get fat and happy and drive your Porsche around.

“At Allan Gray, it's not how we think. We start with a clean sheet of paper. We say, ‘What are the companies in the businesses that we would own, if we were true business owners?’”

Shutting out the noise

Ultimately, in order to achieve better returns, Inifer said investors need to practice both avoiding the biases above and learning not to be too swayed by the “noise” that might influence them. He said that “thinking like Spock” essentially involved “distinguishing value from price.”

He concluded by saying: “I think it's really important to understand that value is what you get, and price is what you pay. Price can be volatile. It's driven in the short-term by buyers and sellers active in the market: people's short term behaviour and expectations.

“Value, on the other hand, is what you get. It's stable. Value is available at this point in time – it's just not where you think it probably is."