Why Do We Do the Things we do?

Behavioral Finance is a subject that seems to be, in my experience, overlooked by the vast majority of individual investors.  Investors seem to be so busy looking for that optimal combination of investment products, they fail to stop and examine their emotions, tendencies, and biases, and how these play a huge role in their investment decisions.  Today’s article will provide a brief overview of behavioral finance, describe its importance, and provide examples the reader can identify with.

The following is a general summary of Chapter 1 from a book I found fascinating: Investor Behavior:  The Psychology of Financial Planning and Investing by Kent Baker and Victor Ricciardi .

What is Behavioral Finance?

In general, the field of investor behavior combines psychology and investing, and applies this to the financial markets.  When examining a particular area of investing, product, or service, our decision-making process brings together both objective and subjective measures.  Individual investors, whether they care to admit it or not, make decisions based on past events, personal beliefs, and preferences.  Take a specific company such as Apple .  One investor may buy shares because they own, and are happy with, Apple products.  Another may have had a bad experience with technology stocks in the past, and has vowed to stay away from the entire asset class, no matter how promising the company’s fundamentals look.  In both cases, the investor has made an emotional decision, based on beliefs and previous experience.  It never ceases to amaze me just how much an investor’s previous experience invokes an emotional decision.

Traditional Investment Theory

Almost all financial advisors and portfolio managers have been trained using traditional methods.  These methods assume all investors make rational decisions, and include classical decision theory, rationality and utility, risk aversion, modern portfolio theory, and the capital asset pricing model. among others.  These methods are all great in theory, however in the real world, we are essentially humans ruled to a great extent by emotion.

Areas of Behavioral Finance

Behavioral Decision Theory

Behavioral Decision Theory studies how people actually behave and develops models based on behavior.  When many people make an investment decision, they tend to choose a course of action that satisfies their most important needs personally.  Instead of gathering sufficient information, both positive and negative, about a particular investment, they tend to gather information that supports their bias, and discard information that disagrees with it.  An excellent example would be the solar energy market in Ontario.  An investor may read a biased, inflammatory news article, which trashes the industry completely and draws political lines.  This article will balance out every positive piece of information received, creating an inaccurate bias, causing the individual to swear off investing in solar.  At the same time, large institutions such as TransCanada. Enbridge. and KKR are investing hundreds of millions in ON solar facilities, reaping tremendous profits, and have little concern for the noise created by politically motivated and biased articles.

Prospect Theory

Consider the following potential decisions.  For each decision choose the preferred option:

• Decision 1- Choose between A, a sure gain of $240, and B, a 25 percent chance to gain $1000 and 75 percent chance to gain nothing
• Decision 2- Choose between C, a sure loss of $750, and D, a 75 percent chance to lose $1000 and a 25 percent chance to lose nothing

Which did you choose?  In the actual study (Kahneman and Tversky, 1979), 84% of respondents chose A, and 87% chose D.  The interesting aspect of this is that choice A indicates risk aversion and choice D is the riskier option.  Traditional theory would assume all investors would choose A and C, but in reality, only prospect theory would account for behavioral differences.  It is interesting that behaviour affects our decision-making to such a great extent.

Framing

The way investment options are framed affect choices to a great extent.  This is very evident when discussing investment yields with an investor.  Too many investors simply choose the investment product with the higher number, say 10% vs 8%, and either gloss over or completely ignore the underlying risk associated with each investment.  The higher number attracts us like a magnet, causing emotional decisions, which can lead to big mistakes.  In many cases, it would be more appropriate to earn 6 or 8% with lower risk than 10-12% with greater risk of loss.

Buying What You Are Familiar With

The general principle, as espoused famously by Warren Buffett, is to only “buy what you know”.  While this can work well for some investors, for others it can become a detriment.  A positive example is to become familiar with, say, Canadian financial stocks.  If you understand the differences, and opportunities presented, across the spectrum of financials, you can perhaps gain an edge in picking winners.  On the flip side, if it happens to be a terrible time to purchase Canadian financials, you may lose no matter which one you pick.  Not taking the time to understand various investment classes, or if you should be in a particular sector overall, can become damaging to results.  Another example, which in my experience is extremely prevalent, is public vs private investments.  Because we are saturated daily by public stock market coverage, this tends to be the area most investors focus their attention to, and the private markets are ignored because they are unfamiliar.  This media and familiarity bias can prevent an investor from uncovering opportunities.

Overconfidence

This is a big one, and a trap that I have witnessed many investors fall into, which can lead to heavy losses.  Studies show that men who trade investments frequently tend to be the most overconfident.  This can be manifested as a view of superiority, possessing greater skill and knowledge than others, or being better than average.  This could result in expectations that are overly optimistic.  For example, have you ever had a financial advisor assure you that he/ she could generate 10% returns per year over the long run?  As it is impossible to assure anyone of such an outcome, you are being presented with false assumptions, and the basis for this is overconfidence.  Think about your current financial advisor.  Are they realistic, explaining risks as well as expectations, or do they fall into the overconfident category?

Regret Theory

A widely documented investor bias is the disposition effect.   This is the tendency to hold onto losing investments while selling winners early.  The emotions of regret and pride are often associated with the disposition effect.  Many investors also make impulse purchases of investments because they do not want to experience the regret of missing out on a “great opportunity” that all of their friends are participating in.  Not wanting to be left out is a strong emotion that can lead to terrible decisions.

Summary

In my experience, we all tend to make decisions based on emotions, which can sometimes lead to mistakes.  The first step towards controlling your own negative tendencies is the most difficult:  look in the mirror.  Ask yourself if you have any or all of these tendencies, biases, and emotions when it comes to investing.  Personally, when I started in the investment business in 1993, I thought mutual funds were the be-all-end-all.  Then, as time went on, and I was exposed to many different investment types, I learned to recognize when I may have an emotional bias towards an investment or category.  Today, I make great effort to recognize the circumstances which might affect emotional decision-making, assess how valid my “gut instinct” is, and always endeavor to stay rational and logical.

To learn more about how successful institutions invest, and avoid the emotional pitfalls associated with behavioral finance, download the FREE Guide to Real Asset Investing located to your right.