Students of finance learn about Modern Portfolio Theory which provides a process for constructing the “ideal” portfolio of investments to maximise the expected return based on a given level of risk. Standard finance theory is designed to provide mathematically elegant explanations for financial scenarios based on assumptions of perfect rationality, perfect self-interest, and perfect information. The theory illustrates what the “rational” investor should do.
Unfortunately (or fortunately!), real-life does not quite operate with precise, elegant conditions. Humans do not always make simple, rational decisions or behave objectively; particularly in times of stress or challenge. In practice, we all (investors and advisers) have biases that thwart effective decision-making, and make determining the “ideal” portfolio significantly more abstract than portfolio theory would suggest. There are many books (such as Why Smart People Make Big Money Mistakes1) written about this more recently studied topic; “behavioural finance”. It examines what investors actually do in the “real-world”.
Whilst it is impossible to completely eliminate these biases from our decision-making processes, being aware of them can help minimise the risk of mistakes and of making poor investment decisions.
Basically, biases are classified as either cognitive errors or emotional biases2.
Cognitive errors are classified further; some are due to our beliefs, and others result from how we process information.
Some examples of belief biases include:
• Confirmation bias – according to Warren Buffet, “what the human being is best at doing is interpreting all new information so that prior conclusions remain intact”. We tend to seek out information that reinforces our pre-existing beliefs, as we discount information that contradicts or challenges them.
• Representativeness bias – have you ever classified new information based on past experiences, possibly over-emphasising recent high returns, without considering the long-term or the probability of such returns continuing?
Persevering with beliefs can cause investors to get caught up in “herd-like” behaviour or to believe that “it is different this time”.
Information processing biases are often caused by using heuristics or “rules of thumb” (mental short-cuts).
An example of an information processing bias is:
• Anchoring bias – have you ever been fixated (“anchored”) on a particular piece of information? Where every piece of new information is viewed in light of that reference point? Sometimes, those “anchors” are no longer relevant pieces of information. Model economies and companies change, and they need to be evaluated considering the current information.
Emotional biases are more frequent than we would like to admit. We might opt for the status-quo because we fear change or wish to hold on to an investment because our grandfather established it for us on trust.
Fear and greed, hope and pride all affect how we invest.
Loss aversion occurs when investors place greater importance on avoiding losses than generating gains from their investments. In fact, some studies estimate that avoiding losses is 2 – 2.5 times as important as gains. Would you prefer Investment A which offers a 50% chance of a $12 return and a 50% chance of an $8 return, or Investment B, which offers a guaranteed $9.50 return? Most investors opt for Investment B, even though Investment A offers a higher expected return ($10).
An investor who sold down their investments through the Global Financial Crisis (GFC) could very well suffer from loss aversion.
Emotions can have a complex affect on investors. Recognising and self-regulating them is a factor in successful investing.
Biases cannot be avoided or overcome. But once they are understood, it is possible to safeguard your portfolio from their effects. A practical way to do this is to model your financial future and determine your portfolio’s required level of risk. Adopting a goals-based approach to financial planning and wealth management often assists investors to achieve their goals rather than have their portfolios subjected to “behavioural risks”.
Disclaimer: This article contains general information only and is not intended to constitute financial product advice. Any information provided or conclusions made, whether express or implied, do not take into account the investment objectives, financial situation and particular needs of an investor. It should not be relied upon as a substitute for professional advice.
1 Belsky, G and Gilovich, T, 1999, Why Smart People Make Big Money Mistakes–And How to Correct Them: Lessons From The New Science Of Behavioral Economics, Simon & Schuster Paperbacks, New York
2 Pompian, M Behavioural finance and investor types: managing behavior to make better investment decisions, John Wiley & Sons, Hoboken, New Jersey, p 25.