Understanding behavioural finance can help you manage your assets more effectively

These two quotations neatly sum up why all investors can benefit from getting acquainted with the basics of behavioural finance. When it comes to personal finance, a large part of the result can definitely be influenced by our reactions and personality!

Given the role that behavioural biases can play in our lives, learning to identify their impact on our personal investment decisions is vital. Behavioural finance is a fundamental tool, for it helps prevent the negative effects of our biases.

Behavioural finance is the study of how investors make decisions. Research in this area has developed partially in response to the efficient market hypothesis.

Unlike the efficient market hypothesis, which assumes that investors behave rationally, behavioural finance uses psychology to draw quite a different conclusion.

In the early 1980s, the pioneering work by psychologists Daniel Kahneman and Amos Tversky, as well as by economist Robert J. Shiller, began to attract attention. Through a series of scholarly experiments, they demonstrated that participants made emotional decisions rather than rational, optimal ones. Furthermore, investors sometimes continued to make such choices even after being told why they were counterproductive.

Such studies have shown that, contrary to the basic assumption of the efficient market hypothesis, investors do not always act rationally. They exhibit many irrational behavioural biases driven by emotion. As a result of these erroneous behaviours in response to pricing and risk, markets may occasionally present inefficiencies.

Biases can be divided into two broad categories: cognitive errors based on erroneous reasoning and biases based on feelings and emotions.

Even though both lead to illogical decisions, cognitive errors can be corrected more easily with counselling and education. Conversely, emotional biases are harder to prevent because they stem from a spontaneous drive rather than a reflective exercise. Being able to distinguish between the two types of biases can help determine the best way to guard against them.

Researchers have identified many behavioural biases. Here are the most common ones and their consequences for investors.

Psychologist and economist Daniel Kahneman studied this emotional biase, which cause people to react more strongly to losses than to gains, and for his efforts earned the Nobel Memorial Prize in Economics in 2002. He found that individuals are much more sensitive to the prospects of losses. If we illustrate this behaviour with a utility curve, it looks like this:

In other words, risk-averse investors much prefer avoiding a loss (or regret) over making a gain (or attempting something). As a result, their investment decisions seek to avoid losses at all costs, even when the probabilities of making a gain are equivalent.

A classic example of this asymmetric reaction occurs when an investor seeking liquidity keeps a loser but sells a winner, without analyzing the future potential of each.

If the investor were not subject to this bias and acted rationally, he might discover that the stock he should sell is the one trading below its purchase price.

The consequences of aversion to risk and regret are multiple. This biase leads investors to:

• maintain positions in the hope that the securities will recover
• sell out of fear that gains will erode
• be overly cautious in their investment choices, leading to long-term underperformance and failure to achieve goals
• adopt herd behaviour (do as the majority does) and limit themselves to the shares of well-known companies

This bias, which has both emotional and cognitive characteristics, arises from our tendency to overestimate our intellectual abilities.

This over-reliance usually translates into a propensity for investors to overestimate the likelihood that their predictions will materialize. Thus, they underestimate potential risks and overestimate expected returns. This bias can lead to a poorly diversified portfolio presenting a considerable risk of loss.

This form of cognitive error involves relying on a reference value to make estimates, judgments and decisions.

Human nature being what it is, when people have to estimate an unknown value, they tend to rely on an initial value, namely an anchor point that they adjust upward or downward.

This information-processing error is expressed in various ways.

For example, in a game of “heads or tails,” if the first four throws come up “heads,” we will be tempted to choose “tails” for the next throw. Yet the previous throws – the anchor point – have no affect on the result of the fifth throw. The probability is still 50-50.

In the investment world, the typical anchoring bias is to rely on past performance to get an idea of future performance. In other words, the use of a reference point, often recent, will take precedence over other factual information and will influence our investment decisions in a negative or unsuspected way.

Another common type of cognitive error is to assign a different value to money depending on where it comes from or how it is spent.

The most common example is the way people use an inheritance compared with other types of cash inflows. Given the unexpected nature of this source of money, people almost always opt for a frivolous expense or undue risk taking.

When we draw up our budget, it’s normal to divide our expenses into categories, such as housing, food, kids and vacation, in order to get a clearer picture.

This approach undoubtedly has its merits; but when it comes to portfolio management, it’s vital to keep the overall objective in mind and apply a holistic strategy rather than assigning specific roles to investments.

Money is money, regardless of its source or the use made of it. Investors who do not approach their assets as a whole, but instead compartmentalize them, tend to lose sight of the interaction between them and sometimes end up with a portfolio that lacks diversification.

This emotional bias manifests itself when people assign a higher value to an asset when they own it than when they don’t. This behaviour runs counter to economic theory, which states that the price a person is willing to pay for a good must correspond to the price at which he is willing to sell it.

Psychological research shows that people have a tendency to set a higher selling price for goods they own than they would pay to acquire them. In other words, because you own an asset, you assign it a capital gain!

According to studies, this bias is a consequence of other biases, such as anchoring and aversion to loss and regret. Within a portfolio, this type of behaviour is especially obvious when an analyst assigns an attractive outlook to a security already in the portfolio, yet is reluctant to increase its allocation or weight in the portfolio.

This bias can lead to:

• an inability to sell securities and replace them with others that have better prospects; and
• an asset allocation that does not match risk tolerance or financial objectives

Unfortunately, there is no magical solution that can immunize us to human behaviours that affect our investment decisions adversely. Even professional investors occasionally fall prey to them!

The good news is that if you become aware of the biases, you’ve already put yourself in a much better position: you’re now familiar with the phenomenon and may have the reflex to remedy it.

Beyond that, there are of course some helpful cardinal rules that you can periodically remind yourself of:

• Base your decisions on in-depth fundamental analysis and up-to-date information
• Avoid trends, rumours and flavours of the month
• Take time to gain a full understanding of information that contradicts your initial thesis
• Detach yourself from the short term and emotional ups and downs by not checking your portfolio every day
• Maintain a goal-oriented strategy that encompasses all assets and takes a long-term perspective

Another way to avoid behavioural biases is to hire professionals. An irrational decision can cost you dearly.

No matter why you invest or the type of account you use (RRSP, TFSA or other), better savings and investment behaviours will help you reach your goal faster, whether it’s to enjoy life in retirement or to achieve financial independence.

FÉRIQUE Investment Services, the principal distributor of the FÉRIQUE Funds, can help you with your decisions. Even though mutual fund advisors and representatives are not immune to behavioural biases, their main objective is provide guidance so that you can respect your investor profile. They will provide advice designed to help you make the most advantageous transactions.