Christine St Anne: Vanguard's, Steve Utkus joins us today to give us an insight into the mind of an investor.
Stephen Utkus: Well, what we've recognized is that there is a psychological aspect to decision making and that makes us in some ways deviate from what might be rational ways of deciding particular decision. Framing and defaults are two ways in which just the way a problem is presented to us. Fundamentally changes our decision making.
For example, if in Australian superannuation system most members are defaulted into an investment choice and so few, many people if you ask them, would say, I like to make my own investment choices. But in fact few do, psychologically they are disinclined to take action, they are subject to what we call inertia.
Just an example of how powerful defaults can be, in a whole range of settings it has, whether its membership dues or other sorts of arrangements where defaults, figure individuals tend to go with the default out of a sense of inertia. Even though if you ask them, would you like to exercise investment choice in your super fund, most would say yes. That’s a sort of psychological attention.
We know that, many years ago I think it was in the 19th century an economist identified this notion in human psychology. He called it a defect in telescopic faculty, the inability to look forward to the future and think about the future. And fundamental for all of our retirement savings problems is this defect in telescopic faculty. Some people are very patient and future oriented and think carefully about the future they plan for the future. The think about the superannuation, they think about their other assets and they are planners we call them sometimes. They are patient.
As it turns out a number of us are impatient, focused unduly on the present. You may be familiar with the Aesop Fables, between the grasshopper and the ant. The ant accumulating savings for the winter, the grasshopper sort of enjoying the summer and not accumulating any goods for the winter. That's sort of the old – that comes – so (beside) the impatience versus patience in human beings goes back thousands of years, and the contemporary version of this is how good we are at planning for the future.
I think where overconfidence really plays a role is as we think about our portfolios and our investments and think about the future. One of the psychological aspects of decision-making that I find very fascinating is this tendency for all of us to project the future to be just like the past.
Now economists have this fancy term for it, they call it auto regressive expectations. But what they simply mean is, what I expect of the future is going to be something like what I'm experiencing today. Now how that plays out in financial markets, is when we've had great bull run in equity markets as we've recently, that builds a sense of overconfidence about the future, that the party will last forever. And so this sense of projecting a true rosy future and unrealistically rosy future is really at the heart of what overconfidence is.
Well, it's actually the flip side. So in rising markets, as markets are doing well, I become very overconfident and I expect them to continue. Now as markets begin to deteriorate, you might think, well, then people would adjust their expectations downward and that would be one thing. But we know from that behavioral economics literature, that psychologically, a $1 worth of loss actually feels like $2 worth of loss.
So if you lose 20 per cent of your – in the equity portfolio in a market – typical market downturn, it actually feels like you have lost 40 per cent. So what happens on the upside is we exaggerate the positive and become over confident about the future. And then on the downside our sense of loss is accentuated by this, what we call loss aversion feature. A fact that, there is an actual coefficient of loss aversion, it's about 2.2 to 2.4. So it's not exactly 2 times. But you can actually measure how psychologically painful people find losses and it's about double, double or more. And it can vary.
The really patient – let's tie it back to patience, the patient forward-looking investor tends to avoid the overconfidence in the upswing and also has – is more finely attuned and has not become loss averse in the downturn. The less impatient – the less patient investor, the more impatient investor is one who responds more strongly to those behavioral biases.
And what I ask individuals to do in their own decision making is try to get an external benchmark, an independent point of view from a friend, a trusted advisor, another source of information. I think one of the biggest – one of the easiest ways to moderate behavioral bias is to externalize the information that you are getting and don't simply look for information that confirms your own view.
So for example, if you are an enthusiastic growth investor, you should be reading about people who are cautious and pessimistic to, providing antidote to your own sort of over confidence. Similarly, if you an ultra-cautious investor, you should be looking at aggressive investors and seeing what case they are making to provide that sort of external antidote. So if you seek out more of use, more external reference points, you can help with some of these biases.