Behavioural Finance

It would be ideal if investors and markets executed solely on analysis of economic and financial data. However, this is not the case as we have seen in weeks past, emotions play a large role inside the market. The market is made up of a pool of many investors, in essence- a pool of biases, opinions and lots of different emotions. Studying these different biases, emotions and psychological influences of investors is known as ‘behavioural finance’. Often when the markets seem to be in a manic state, investors try to predict what it is going to happen next because of fear or greed. With a pool of people all simultaneously doing this, it is normal for market prices to look topsy-turvy, to say the least.

“Behavioural finance attempts to identify trends in how individuals make investment decisions that differs from the way that analytical traditional finance would.” – CFA Institute. According to the Corporate Finance Institute, behavioural finance looks for patterns in individual’s behaviour, biases and cognitive errors which leads them to make wrong choices.

“Behavioural Finance is becoming more and more accepted, as it has begun to unfold what drives investor and market behaviour which cannot be explained by analytics and traditional finance. However, understanding behavioural drivers and patterns entirely, is not possible because human behaviour cannot be fully predicted with scientific precision” – CFA Institute. “A frequently mentioned quote surrounding the irrational behaviour of market participants was allegedly said by Sir Isaac Newton. A man who founded “Newton’s Law’s”, the understanding of gravity and inventor of modern calculus, stated, after losing copious amounts of his money during the acclaimed “South Sea Bubble” in 1720, that he “could calculate the motions of heavenly bodies, but not the madness of the people””- Paul Crawford.

Research has found a variety of decision-making behaviours called ‘biases’. These biases can affect all types of decision-making, but have particular implications in relation to money and investing. These biases relate to how we process information to reach decisions. They sit inside our subconscious mind, often instinctively guiding our decision process. They serve us well in certain circumstances. However, in investment they may lead us to unhelpful or even hurtful decisions. Being aware of behavioural finance can help investors check their decision-making processes. There are various types of perceptions discussed in behavioural finance. We will be navigating those and using them to check our investment blind-spots. We are unlikely to find a ‘cure’ to removing these biases completely, but if we are aware of the biases and their effect, we can actively choose to act against it. The most important thing is to leave emotions out of the evaluation and check our own blind spots before executing, so we do not become victim to our biases. This can be applied in a situation of: What to do and what not to do when the world around you starts to get hysterical. It is our tendency to significantly overweight the importance of what is happening now, in comparison to the future.

Behavioural Biases’ Effect on Investment Behaviour

Bias 1: Herding
This is a behaviour to try to avoid inside our own investing. Herding, as the name suggests is exactly that – following the crowds. Investors who are not technically clued-up about market correlation, diversified blending and portfolio construction tend to seek comfort in what “everyone else” is doing. Often when everyone is flocking to a particular investment or share, herders will also want to jump in because they do not want to miss out. They do not know the technical reason as to why they are buying, other than; the price is going up and everyone else is doing it. This is precisely what causes market ‘bubbles’ as well as the contrary; market ‘crashes’. People do not only herd when things are good, they do it when things are bad as well. For example, when a stock market index starts to fall, often investors want to get out of their holdings even in mutual funds to avoid losses. More savvy investors want to understand the reason behind the movement before just following the ‘herd’. The savvy investor knows that the fall of markets usually involves a hand-full of large investors exiting their holdings- and this is the reason for the drop in price. This is called ‘the whale effect’ in investment theory.

Bias 2: Managing diversification
Diversifying a portfolio is incredibly important. Most finance and investment specialists understand how to do this. Behavioural finance research shows that investors understand the importance of diversification, however struggle to apply it in practice. Many investors struggle to balance risk-return inside their portfolios and rather use a method called; the ‘1/n’ approach. Here, investors take a range of funds and allocate to them equally to make up their portfolio. They believe that simply holding multiple funds is diversification. For example, a combination of 5 different Balanced Funds, is not diversification. This method ignores specific risk-return characteristics, correlation, asset class exposure and other relationships between the funds selected. The opposite is also true, where investors may prefer to stick with assets that they are familiar with. This rules out other assets which are actually beneficial for them to hold inside their portfolios.

Bias 3: Overconfidence
Psychology has found that some people are inclined to overconfidence in their decision making. Many studies have shown that learned individuals like lawyers, doctors’, CEOs and students overrate the accuracy of their views on the future. Overconfidence has a direct link to ‘control’. Overconfident investors believe they hold more control over their investment’s outcomes, believing it will result in a superior outcome if they are the one’s deciding what to execute on and when. Research from the Vanguard paper showed wealthy investors reported that when they engaged in their own stock-picking during uncertain times, it was critical to their portfolio performance. They admitted that they overestimated their own abilities to understand broader factors influencing their investments.

Bias 4: Using – or misusing – information
We often use mental shortcuts to simplify decision-making in complex situations. This helps us filter through information in order to make a decision. These shortcuts can be helpful, but sometimes they can lead us astray.

There are three classic examples of this in research:

‍• Anchoring.
Often investors can ‘anchor’ on the price level of their previous portfolio value. This causes them to constantly compare the previous value, to the current value, without taking all changes in the market into account. Investors can also be price sensitive to a price they paid for a particular security and in turn, refuse to sell it despite its poor performance.

• Representative Bias
This is decision making based off of what a situation looks like. It reflects the case where decisions are made based on a situation’s stereotypical characteristics, rather than a detailed evaluation of the reality.

• Conservatism bias
This is the idea the decision maker clings to an initial judgement despite new contradictory information.

‍Bias 5: Loss aversion
When markets are on the rise, people are willing to take on more risk if there is chance of gaining more. However, the opposite does not hold true for when markets are on the decline. Seldom, people are able to honestly evaluate how much loss they are willing to take on – until they start losing. Some research shows that people weigh losses twice as heavy as potential gains.

Bias 6: Regret Avoidance
This is commonly known as having ‘second thoughts’. Regret avoidance hinders investors by creating confusion or uncertainty. Often, people will avoid making a decision if they feel that they may regret it later. Having an adviser to timeously encourage execution is key. 

What Can Help These Biases?
Research has shown, that when people compartmentalise investments by ‘goals’, it helps them filter through biases a lot easier. The reason for this, is they are able to see the investment’s purpose/goal more clearly and then apply decisions. Example; short term savings goals, medium term savings goals, long term savings goals. These portfolios vary in risk tolerance, what kinds of assets they are invested in and purpose. The longer term will hold more risky assets for growth while the shorter term will be more conservative. When treating investment portfolios as purposed buckets, it allows the investor to focus on the purpose of each investment in isolation to the others; this helps with managing emotion when stock markets start moving and the portfolios each respond in different ways. All of Fairtree Invest’s income drawing portfolios have been using this bucket approach for years. Once you put all the different buckets together, we see the overall portfolio in it’s entirety, however each section has a different function to play.

This being said, people tend to focus overwhelmingly on the movements of individual investments or securities. Therefore, when reviewing portfolios investors tend to fret over the poor performance of a specific asset class or security or mutual fund in a certain season. These ‘narrow’ frames tend to increase the investors sensitivity to loss. By contrast, by evaluating investments and performance as a whole (with all portfolios combined with purpose), this ‘wide’ frame, has shown that investors tend to exhibit a greater acceptance to short-term losses and their effects, because they can see the bigger picture clearly. “Economists suggested that most investors seek to balance security with the small chance for big winnings.”- Vanguard paper. Thus, portfolio allocations should be based on a combination of ‘insurance’ (protection against losses) and ‘lotteries’ (small odds of a large gain). Shefrin and Statman formalised this approach and designed this pyramid:

“The base layers represent assets designed to provide ‘protection from poverty’, which results in conservative investments designed to avoid loss. Higher layers represent ‘hopes for riches’ and are invested in risky assets in the hope of high returns. This idea explains why an individual investor can simultaneously display risk-averse and risk-tolerant behaviour, depending on which mental portfolio they’re thinking about. Theory also suggests that investors treat each layer in isolation and don’t consider the relationship between the layers. Established finance theory holds that the relationship between the different assets in the overall portfolio is one of the key factors in achieving diversification.”- Shefrin and Statman

It is important for us as investors, to remember the reason why we designed the portfolio when we started investing. Like any good athlete, success only comes when in times of resistance we preserve and bring ourselves back to ‘why’. Our reason for investing (why) is usually the constant when the ‘what’, ‘when’, ‘how’, and ‘where’ starts to bring uncertainty.

– Kheara Kroggel

Article Credits:  

• https://www.cfainstitute.org/search#q=Behavioral%20Finance
• https://www.vanguard.co.uk/documents/portal/literature/behavourial-finance-guide.pdf

Bernartzi, Shlomo and Richard H. Thaler. ‘Naive Diversification in Defined Contribution Savings Plans.’ American Economic Review 91(1), (2001): 79-98.

‍