ZAFFAR SUBEDAR | Protecting yourself from yourself

Behavioural Finance is the application of psychology to financial decision making. By allowing psychological biases and emotions to affect investment decisions, investors can do serious harm to their wealth. Investors who are prone to behavioural biases will take risks they don’t acknowledge and experience outcomes they did not anticipate. 

Zaffar Subedar has over 15 years of experience in the financial services industry and academia. He’s currently with eInvest where he works with advisers and researchers. In his spare time, Zaffar enjoys furthering his knowledge of behavioural finance (his PHD subject area).

Here's a link to more information about Zaff and his work in behavioural finance.

TRANSCRIPT FOLLOWS AFTER THIS BRIEF MESSAGE

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EPISODE TRANSCRIPT

G'day and welcome back to Shares for Beginners. I'm Phil Muscatello. How many of our investing mistakes come from emotions and psychological biases? Warren Buffett said that the biggest obstacles to investment returns are fees and emotions. My guest today is here to rifle through the dark passages of the soul and hopefully show us how to become better investors. Hello, Zaffar.

Zaffar (51s):

Hi Phil, great to be here.

Phil (53s):

Great to have you. I'm looking forward to going through all the psychological undergrowth today.

Zaffar (57s):

Looking forward to it.

Phil (59s):

Zaffar Subedar has over 15 years of experience in the financial services industry and academia. He's currently with eInvest, where he works with advisors and researchers. In his spare time, Zaffar enjoys furthering his knowledge of behavioural finance, which was your PhD subject area.

Zaffar (1m 16s):

That's right. A very long time ago, but in a subject area that I thoroughly enjoyed and I can continually enjoy to this day. And I think I'm very fortunate to observe a lot of behaviours that...

Phil (1m 30s):

In real time.

Zaffar (1m 31s):

Yeah, that literally came out of the lab, so to speak, and they're happening on a daily basis.

Phil (1m 37s):

So is it like that? Is that something that you've worked on theoretically and you're actually seeing things playing out now that as you say were investigated in the lab?

Zaffar (1m 46s):

Yeah, well, most definitely. If I take a step back, so, when I was at uni and beginning the PhD, a very long time ago now, shows my age. But a lot of the studies initially started with university students by psychology professors. So they were natural experiments

Phil (2m 6s):

They were the Guinea pigs.

Zaffar (2m 8s):

Yeah, they were the Guinea pigs. But effectively these professors, predominantly in the US, they examine how people make decisions under uncertainty, which is what we do when we're investing. We're investing where there's uncertain outcomes. And they eventually found that people weren't behaving in line with what traditional economic models were built on. So that created this whole field of behavioural finance that examined in particular how people made decisions. Whereas traditional theory, which a lot of the financial and economic models are built on, they're very prescriptive in how people should be valuing assets, how people should make decisions based on this information set.

Zaffar (2m 53s):

So it was a really revolutionary field and the field has spawned into marketing, it's spawned into government policy. And a lot of your listeners, no doubt, probably read a lot themselves and are probably here doing some nasty things. But hey, we're all investors. And that's the beauty of being able to finance that it applies to everyone: professionals and individuals.

Phil (3m 16s):

They're kind of emotions. We're all emotional creatures, aren't we?

Zaffar (3m 19s):

Yeah, no, we're definitely emotional creatures. But it's really how we make decisions and how we can better ourselves, which is an outcome of these emotions. These emotions trigger us, particularly in uncertain environments, probably to do things that aren't good for us from an investment standpoint.

Phil (3m 37s):

So what's the definition of behavioural finance. What's the laboratory definition of behavioural finance?

Zaffar (3m 42s):

Well, in short, the simple definition is it's a application of psychology to investment decision-making. So very, very short and that's really the short line definition.

Phil (3m 55s):

So investing over the last two years has been extremely difficult. We've all been inundated with negative news: case numbers, worst case scenarios for outbreaks, lockdowns and now war. How does this affect our ability to make optimal investment decisions?

Zaffar (4m 9s):

Yeah, that's a great question, Phil. And what really makes investment decision-making difficult in these types of environment is the volume of information and what type of information that comes to mind. So, yes, you've got a lot of economic commentators, you've got a lot of reports if for an investment decision maker to consider, you've got a lot of economic data, but amongst all that, you've obviously got the usual headlines, the usual fake news clickbait type of headlines that grab a lot of attention and that clouds our ability to make a decision. And when you're in this type of environment, instead of sitting back and making an investment decision over, you know, medium or longer term horizon, we tend to use shortcuts.

Zaffar (4m 53s):

And it's these shortcuts that really cloud a decision making. And, you know, a lot of people may suffer with their wealth by making a decision that's not in their best interest. So it's really that clouding around the volume of information and how we use it.

Phil (5m 11s):

It was interesting reading your article actually, because I've only just recently learned the word heuristic, what heuristic means. And it's really, it's a shortcut, isn't it a shortcut in thinking

Zaffar (5m 21s):

That's right. They're just simple rules of thumbs to make decisions. And I guess an example of non-investment making heuristics is the old chocolate example. So I think about if you've got a chocolate that's right next to you on the desk, you'll grab it. Now, if it's in the kitchen, are you going to walk over there and get it? You're probably not as likely to do that. Now you're thinking, well, how does this make any sense to investments? Well, it does. If you monitor your investments frequently, you're more likely to make a decision. And whether that as students go to bed, most times it's usually bad. That shows us that constantly looking at something isn't good. Say in real life, we know if you look at something you feel you're trying to lose weight, you weigh yourself every day, you'll get frustrated, Gulf Trek early to same thing with investment decision-making.

Zaffar (6m 9s):

If you keep looking at something frequently, you will more likely make a poor decision. So these are sort of common things that happened in real life, in other domains that can also happen in the investment world as well. Hmm.

Phil (6m 22s):

There's an article that we'll link to that listeners can read where you talk about the decisions that Australians were making in their superannuation funds during the COVID pandemic and how many negative impacts occurred with their investments, by the decisions that they made due to fear. Tell us about that.

Zaffar (6m 42s):

Yeah, that was a good study feel. I think, especially given what time period they looked at, which was during the first initial bout of COVID in early 2020, but really the main two studies that they found, which may be relevant to our topic was that they found that the superannuation members, they switched between investment options. But what was important was with these switch over 70% of people in the study had a negative outcome. So if we remember the market tanked and then there was a recovery, so they switched as the market tanked and kept tanking. And then obviously there was that recovery by taking that course of action by monitoring their investments very frequently, that is something that, which was quite adverse to them.

Phil (7m 28s):

So is this in your superannuation options, you get like conservative or aggressive and various ranges along that spectrum, these people moving from aggressive to conservative, is that the kind of actions that they were taking?

Zaffar (7m 40s):

Yeah. So they could have moved from those types of options, whether it could be diversified funds or they may have gone from equities back into cash, change their investment options like that. So that was along those lines. Then when they looked at transaction data

Phil (7m 54s):

And that's what people do is as soon as there's any fear, they start selling and trying to get into some form of safety, but this is not necessarily going to be great for their investment decisions in the long-term isn't

Zaffar (8m 5s):

No, exactly. And there was earliest studies back in the US I think just before the tech wreck, the late nineties. So if we all remember back many years ago when retail broking started, so when retail investors could go online and buy and sell quite easily, they found in the US late nineties that there was a study by an academic Danny found that the retail investors tended to sell the better performing stocks in their portfolio. And they would hold on to their losers and they found over a 12 month period, the ones I sold early went on average to return and other sort of three to 4%. Yeah. And you know, again, that's this whole basis of let's look at these, we've met a profit, let's trade early, get that gain, but then hang on when the opposite happens with a whole that.

Zaffar (8m 56s):

So this, again, this whole use of information, looking at something too frequently, particularly if you're trying to create some medium to long-term wealth with very hard to be immune from particularly as a retail or self-directed investor.

Phil (9m 8s):

I think there's also another study that shows that the best performing portfolios at that time where people had actually passed away, no one was doing anything with these portfolios. And they were actually performing better than most other more active portfolios.

Zaffar (9m 21s):

Yeah, that's right. There's again, yeah. Numerous studies that are showing some buy and hold or strategies with less turnover tend to do better over time. And probably again, if you think about it, you like an investment. If it's an equity investment, you do need time for that thesis to hold. And yeah. Those portfolios definitely that have lower turnover, we'll show those factors.

Phil (9m 43s):

Okay. So let's go through the list of self sabotaging behaviours, and there's a couple of biases that you refer to and one is representativeness. Tell us about representativeness.

Zaffar (9m 54s):

Yeah. And, and, and these self-sabotaging behaviours, they are heuristics. So essentially these are also heuristics, which we discussed earlier.

Phil (10m 3s):

Shortcuts, heuristics shortcuts. Yeah.

Zaffar (10m 5s):

That's right. So representativeness is the tendency for investors to make decisions based on stereotypes where perhaps Nan exist. So it really is looking at information and making decisions, assuming that what's happened in the past, whether this trend, whether it's a short-term trend persist for a longer period of time. And what we do find over time is that using this type of heuristic, there's actually no trend. And they are basically chances or random chances of a fact that lead to poor decisions. So if I give you an example, let's look at earnings of a recently listed company.

Zaffar (10m 46s):

So if we think about IPO's or companies with limited public history, they might show histories of high earnings growth, or if it's an IPO, they might have forecast for definitely a high earnings growth. Now, as an investor, if we think this trend will continue, even though there might only be a couple of quarters of publicly available information, then we could be hit for a rude surprise. When in fact the company's earnings don't grow to anywhere near that level, because we would have gone in and paid a high value for that particular stock and the earnings don't eventually wait, and we get hit. That's probably a common one that's out there as well.

Phil (11m 23s):

And another bias is the availability bias. Tell us about that one.

Zaffar (11m 27s):

Yeah. Now this is a very interesting one. And again, these are all based on how we make decisions based on information that we have, but essentially the availability bias occurs when we make a decision based on recent experience or information that is readily available to you. And that's the key what's readily available to you. So, you know, if you consider you watch the news six o'clock news or whatever, Tommy watch the news, if a particular stock or particular market gets quoted in the news, then that's what you will base your decision on. So yeah, the ASX was down today. Therefore I'm not going to invest tomorrow or the ASX's been down all week.

Zaffar (12m 9s):

I'm not going to invest now because I'm worried about the outlook. So where you get your information from and how frequently you source that information from does affect your decision. Conversely, other studies have found if we use availability bias, particularly at a high level, such as looking at market data. As I just gave an example of, we tend to overreact more because we think, and we overestimate that these bad events will continually occur and other, you know, we don't invest or we make a decision of like, let's cut out and get out of here. So I say it's a very crucial bias that we need to keep an eye on, of where we source information from and how we use that information to make a decision

Phil (12m 51s):

In preparing this interview. I recently interviewed a psychologist about the emotions that sabotage good investment decisions. And this was his list, greed fear, euphoria, despair, overconfidence, and strangely enough regret. Do you have any comments on that list?

Zaffar (13m 7s):

Yeah. Look, I think that's a great list. And if you read the literature, not just to the academic one, but a lot of the investing literature that's out there, these emotions that the psychologist mentioned, they hit all the relevant characteristics. But the only one I would probably add to that list is really myopia. And that's that being short-sighted in it's, that's really detrimental to wealth creation. Again, if you are so shortsighted and you try and identify patterns based on information that's readily available, and particularly if it's not thorough or accurate information, then this is the most critical behaviour that you would have to your long-term wealth creation, being shortsighted.

Zaffar (13m 59s):

It's very hard to avoid. It's very hard to avoid in other parts of life, but investing to create wealth is absolutely devastating. Like we've quoted early a couple of studies, but all your listeners out there. I know myself. I, when I initially started investing myself directly, I was myopic move, being younger and being a bit more Bravo. It's definitely something you want to avoid a myopia. Just next time you think about doing something head over to Specsavers.

Phil (14m 29s):

We are pattern recognition, creatures. Aren't we, I mean, we're actually built to recognize patterns, but sometimes we can just make up patterns out of thin air almost can't we,

Zaffar (14m 39s):

Well, we look for patterns where non-exempt

Phil (14m 43s):

Might exist.

Zaffar (14m 44s):

And that's the crucial piece there that when you look for these patterns, do they happen over time? And when these patterns occurred, what are the drivers of these patterns? So if you're looking at a company's price chart, well, what's been driving this price movement either up or down, what's happening on the fundamentals. What's happening to that investment relative to its peers. You need to consider more than that. Just one piece of information. You need to look at the information in totality.

Phil (15m 18s):

Another thing that I've been really interested in thinking about lately is about the idea of shame. I mean, it's not just regret. You can make an investment decision, it goes bad and you feel shame. You feel like a loser and that's a really powerful emotion. Is that something that you've seen or has academic study that?

Zaffar (15m 36s):

Yeah, so there's a couple of ways you can look at shame and from the behavioural finance literature, the item, I think that really summarizes shame is loss aversion. So loss aversion, loss aversion is probably something that really relates to shame. And the piece that loss aversion really summarizes is that it describes the pain of losing on an investment and what the psychologist and what the behavioural finance academics have found is that the pain of losing is two and a half times more than an equivalent gain.

Phil (16m 11s):

How do they measure that? I've heard that the statistic, how do they measure that?

Zaffar (16m 15s):

Oh, that they've measured that through a number of studies around uncertainty and will experiments dive in the predominant way of doing that. And this two and a half times, it's not just with university. Students is with individual investors. I think I did a study a long time ago with finance professionals. This was just after the GFC. And I think they viewed the loss about 40 times more than an equivalent gain. Say, if you think about

Phil (16m 43s):

It, they had professional skin in the game. Didn't that's

Zaffar (16m 46s):

Right. And I think the way interpreter is like, if I've gained 10%, I feel good, but if I'll lose 10%, I feel very, very bad. That's the sort of qualitative summary of it. But I think the other point around loss aversion and shame, there are a couple of points. The reason why we hold onto our investments. So go back to that loss aversion. You've lost five, 10%, but it feels two and a half times more than that actual loss. The piece is we now feel that hang on, I liked this investment. I've liked it for a number of reasons, but I think it's going to rebound. So this is where we are letting the loses ride because we, I, in the hope that this investment will rebound, the second point is it's also that attachment.

Zaffar (17m 33s):

You've done so much work on this investment. You spend a lot of hours sourcing information, making the decision. And probably thirdly, you've gone out and told other people. So you've got their shame of hang on. I'm going to end up here with egg on my face because, you know, I spent so much time looking at these investment and now it's underwater by 10, 15% on eight to hold onto it because he's going to come good. So this is a challenge that these shame or this loss aversion that is in a, something that explains why we ride loses in the hope of our investments to recover. But if we go back to this earliest studies, we tend to do the opposite and cap out our winners and ride those losers.

Zaffar (18m 15s):

And also the other thing I should say is someone will say, what about tax and those sort of things? Well, yes, it could be some, a tax advantages there with our riding, some of the losers, but you know, that's an area where I recommend you talk to your tax agent on.

Phil (18m 29s):

Yeah, that's right. It's not about tax. It's about making money in the end. Isn't it?

Zaffar (18m 32s):

Well, that's the old saying, isn't it. If you're paying tax, you're making money,

Phil (18m 35s):

What about searching for gurus? I think there's a lot of people who want a guru as well.

Zaffar (18m 41s):

Yeah. And this is, there was a very rare, peculiar study is actually done by some New Zealand academics, probably mid two thousands and they call this the socialization effect. So if you think about it, you're going into a new environment. Think about you're going into a new workplace or you're going into a new school. If you're a child or you're going into some sort of a professional environment. When you walk into that environment, you from a previous experience, what your average was, your average, you know, are these people really good to work with? Yeah, they're pretty good. They're average compared to what I've experienced in the past.

Zaffar (19m 22s):

So all of a sudden, if you were at a previous workplace and your average, might've been seven for your previous employees in terms of how to work with and all that sort of jazz. Now you get a new workplace and all of a sudden it's a new environment and that average might be six, or it might be five or whatever it is it's declining, or it could go the other way. So by going into a new environment, you start to change your mean. Now, what does that mean for investing back to your point about gurus? You will start sourcing people at the barbecue. You will start following other investment commentators that are out there and that now frames your environment to make a decision.

Zaffar (20m 5s):

So if they're a good stock picker or their average stock picker, do you measure that? And if they're not a good stock picker, if you haven't objectively measured that guess what your new average is going to be a lot lower than perhaps what it was before. So it's very, very crucial what environment you're in and where you source information from to help you with again, your long-term wealth.

Phil (20m 26s):

And it's also worth knowing that gurus are fallible as well. And maybe don't even have any better idea of investing that you do.

Zaffar (20m 34s):

Oh, that's right. And we've seen now the 10, second investment updates you get on tick-tock. So the world is getting a lot more complex than what it was probably just two years ago.

Phil (20m 45s):

Yeah, no, I wouldn't have made any money without those Joke listeners. Yeah. So the gurus that are setting themselves up on YouTube and tech talk and all over the social media. Now they're not going through the rigorous process that many professionals in the financial industry have to do to justify their purchases and buying and selling decisions. What's something to watch out for. And how can people think about these supposedly gurus?

Zaffar (21m 14s):

So I think one way to look at gurus and anyone that you use to influence your decision-making process is to consider that their track record. So it's not just by a particular investment is like, well, overall, how has their portfolio, do they even have a portfolio? Do they show their holdings? Do they show what their investment mandate is? So for example, some people might be high risk versus someone that's low risk. How do you compare the pair so to speak? So that's why I probably have a look at the institutional investors or the professional investors. So if you look at particularly active ETF providers, they've got all their holdings on the,

Phil (21m 51s):

I have a process and they tell you exactly what they're doing, how they're investing and their reasons for investing in

Zaffar (21m 57s):

That's, right. They're very transparent. They've got a monthly update where they talk about what they've done with the portfolio, what the outlook is, what, and what were the major drivers and contributors to the performance over the last month. So you've got a transparent record there, and obviously you can go through and see their investment processes as well. And that's a bare minimum amount of verification you should be using to look at investment recommendations, or obviously the performance of that type of investment you're considering. So there's a difference there between gurus and professionals. And again, looking at track records and making sure the results actually valid is important. Yep.

Phil (22m 36s):

For me as well. It's the idea that you've got to understand that there is a process you don't get tickers served two on a plate. A lot of people come in and they want, they want to be told what to buy and sell. And that's no way of achieving commitment to a company or a portfolio that you're putting together.

Zaffar (22m 52s):

Yeah, that's right. And usually someone that's doing a recommendation has got a different incentivisation, whereas a active manager or a professional manager, they are managing to a mandate and you need to consider if that investment will have a role in your portfolio.

Phil (23m 8s):

Okay. So we've heard about these biases. What are the shortcuts that we can take to become aware of them and be able to basically put these biases back in the place where they should be, which is not affecting our investing decisions.

Zaffar (23m 22s):

Yeah. And this is a, it's a great question. I struggled with myself for a long time. And look, I studied this for a period of time. It says very difficult to do first of all. And if you commit to this journey, there's no doubt you will be a better investor. I think the key thing is if you can identify some of these biases, you won't feel as ruffle, definitely as much during some of these panic moments or the moments of volatility that we've been going through. So it's definitely an exercise worth doing. And I guess one of them, and we just discussed, it was a really keeping a record of your investment decisions and particularly where you were really confident with the decision. How did that go? It's a track of that.

Zaffar (24m 2s):

You know, that's probably the first key point. So where you were feeling over confident, very high conviction call, how did that investment decision go? And also what sources of information did you use? You must be consistent. So if you're looking at Australian shares or you're looking at global shares, what sources of information, who else were you listening to ensure that you are consistent? Because whenever you're buying or selling, it becomes a relative decision. And you want to ensure that you use the same sources of information to come to that conclusion. Firstly, obviously don't monitor results too frequently. Whenever you purchase something, particularly if it's a risky investment, there will be volatility.

Zaffar (24m 44s):

Use that time, use that volatility to a ride out your decision, give it time. So that's also important. Again, don't be my big, let your investment thesis mature. Another one it's probably a little bit more qualitative is, is investment out of character. So if you've historically been someone that's invested in listed investments, and now you're considering something that's not as liquid, such as a venture capital or private equity, private debt, why going down that path and what prison are you going to look through to evaluate this investment? So that's something we should look at, particularly I think with the new sorts of investment offerings that are out there, new asset classes, be it cryptocurrency or a more sophisticated type investments.

Zaffar (25m 32s):

I also think you need to consider the multidimensional nature of risk. So it's not a particular risk to an investment, but what about things such as credit particular relationships who we know what's happening, if you've invested with anything linked to Russia, think about those things. When you're investing in something peculiar or something that's higher risk, is there one or two other qualitative risks that may affect that type of business that you can't see in the financial statements? So that's something probably you have to keep an eye on and finally think about your information sources, ease using the street research or using that traditional broker research.

Zaffar (26m 13s):

You may be getting off your retail trading site, giving you a competitive advantage. If you're looking at large cap stocks, it's probably difficult to get that competitive advantage by just using broker research. You need to consider when they're all

Phil (26m 26s):

Doing it, aren't they they're there for

Zaffar (26m 29s):

Research. You probably need to do a bit more work around those aspects there. And I think finally, the other piece is just be careful with how you socialize your investment decisions. So whether you're at a barbecue, whether you're at a pub or any sort of social settings, it's just human nature to hear the good stories, but it's at one bad story that may give you second thoughts when you're looking at a particular decision. So, you know, always consider the old anecdotes that are out there with a grain of salt. Because as we know with human networks, we do like to show ourselves in the best light.

Phil (27m 10s):

It sounds to me it's all about having a process. Isn't it,

Zaffar (27m 13s):

That's right. Feel and look at eInvest. We've got professional teams across Aussie equities and fixed income and those specialists, yes, they invest according to their mandates, but they've got deep teams, teams of professionals that are only focused on investment decisions day in and day out. And they challenge each other. They challenge each other where they're getting information from. Are they consistent with their calls and how they measure up on a frequent basis. And also importantly, in these sort of environments, where are the opportunities? So, you know, for a professional, it's just as important to look at your information sources, but you've got the extra layer of having transparency with your investors.

Zaffar (27m 58s):

And that's why it's fantastic at eInvest. We've got some great teams that look right under the hood for opportunities, whether it's in Australia or in fixed income globally as well. And they've been quite a robust in these times of volatility.

Phil (28m 13s):

If people want to find out more information, they can go to the website, which is einvest.com/BF for behavioural finance, of course. And you can ask questions, get some more information and links to articles about this as well. Zaff Subedar, thank you very much for joining me today.

Zaffar (28m 30s):

Thanks Phil. It's great to be here.

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