The myth of the rational investor | Fin24

The myth of the rational investor

Oct 24 2018 09:25
Hannes Viljoen

Hannes Viljoen is a senior manager in the advisory team at Alexander Forbes Investments.(Picture: Supplied)

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Economists, asset managers, investment managers, product developers and the likes all use the “rational investor” when making predictions and assumptions. 

A rational investor, or rational behaviour, refers to the action or decision-making criteria of a person so that the optimum level of benefit is reached. 

But is the average person rational? 

We base so many model assumptions on this ideal, but does he or she actually exist? 

The existence of biases leads to an unclear answer. 

Cognitive biases relate to information processing. It relates to the way we think and argue. 

Cognitive biases can lead to an illogical deviation from rationality and lead to poor decision-making.

A classic example of a cognitive bias is the gambler’s fallacy. If you flip a coin and the outcome is tails six times in a row, our inclination is to put a higher probability on the next coin toss being heads. 

But in reality the probability is 50/50, as each coin toss should be seen as an independent event that is not influenced by previous coin flips. 

In a Monte Carlo casino in August 1913 the roulette ball landed on black 26 times in a row before a red number was thrown. 

People who fell prey to the gambler’s fallacy that night believed that the probability of a red number being thrown increases with each black number being thrown and consequently lost a lot of money. 

In reality the probability of a particular number being thrown on each turn of the wheel should be equal. 

Loss aversion is another well-known bias based on the tendency of investors to prefer avoiding losses over the possibility of obtaining gains. 

The pain felt through a loss outweighs the joy felt over an equal gain.

Daniel Kahneman and Amos Tversky coined the term and, through studies, estimated that people fear loss twice as much as they relish success. 

According to the social psychologists, it hurts twice as much to lose R1 000 in an investment as an equal gain of R1 000. 

Is that rational? Is a R1 000 not equal to a R1 000? 

Anchoring is a bias which refers to fixing expectations on previously observed numbers, leading to an inability to make objective decisions based on current information.

Have you ever walked into a shoe store, tried on a pair of shoes that you liked only to look at the price tag and see it costs R7 000? While packing it away, the sales assistant asked “do you like them” only for you to reply “sure, but R7 000 is out of my price range”.

“You are in luck,” says the assistant, “they are on sale, 40% off.” 

“Bargain” you think, and put it on the card. Even though R4 200 is way above what you normally pay for shoes, it is way below the anchor of R7 000.

Investors and advisers are not immune to irrationality. We state as a matter of law that “past investment returns are no indication of future returns”, yet we use back-tested numbers to cement and convince ourselves and our customers of an investment decision. 

We design retirement solutions that are based on an individual buying an inflation-linked life annuity at retirement because that is surely what the rational person will do?

Whereas we are well aware that more than 90% of annuities taken out in South Africa are living annuities (according to data from Asisa). 

We know that people not being able to retire has, thanks to great past returns in the South African market, not been because of bad returns, but because saving rates are too low and people don’t or can’t afford to preserve retirement savings when they change jobs. 

A rational person will hence spend time on solving the problems that are in our direct control, right? 

But, we spend by far the majority of time, effort and direct client attention on how we can increase the returns instead of the outcome, which is causing the problem – and which is to some measure within our control. 

So what is the solution? 

Irrational rather than rational thinking? A case can be made for that, but changing human intuition might be a step too far. 

Leave it to the professionals to decide what is the best course of action? After all Henry Ford said “If I asked people what they wanted they would have said a faster horse.” 

I think the solution lies in probably the longest-practised human ability that we still struggle to master on a continuous basis: listening. 

Hearing is not enough. We need actual listening. Listening to the client and understanding what they actually, behind all the noise, want, need and desire. 

Listening to the data and understanding that you need to read from the data, and not into the data what you want. 

It is then the job of the professional to educate the client on what is not only possible, but what indeed is probable. And to implement the needs, wants and desires of the client.

Listening is one of the things robots have not yet been able to master. Not yet. 

“Listen” carefully to some of the suggestions we make in the articles of this edition of Collective Insight. 

Hannes Viljoen is a senior manager in the advisory team at Alexander Forbes Investments.

This article originally appeared in the Collective Insight supplement in the 25 October edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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