Understanding Behavioural Finance: Biases in Investment Decisions and Their Impact, Study notes of Finance

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Behavioural finance

Understanding how the mind can help

or hinder investment success

By Alistair Byrne With Stephen P Utkus

For investment professionals only – not for retail investors.

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This document aims to provide a practical introduction to general tenents of behavioural finance and highlights the potential lessons for successful investing. The behavioural biases discussed in this guide are ingrained aspects of human decision-making processes. Many of them have served us well as ways of coping with day-to-day choices. But, they may be unhelpful for achieving success in long-term activities such as investing. We are unlikely to find a ‘cure’ for the biases, but if we are aware of the biases and their effect, we can possibly avoid the major pitfalls.

Behavioural finance holds out the prospect of a better understanding of financial market behaviour and scope for investors to make better investment decisions based on an understanding of the potential pitfalls. This guide focuses on the latter issue. Advisers can learn to understand their own biases and also act as a behavioural coach to clients in helping them deal with their own biases.

Why bother with behavioural finance?

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What is behavioural finance?

Behavioural finance has been growing over the last twenty years specifically because investors rarely behave according to the assumptions made in traditional financial and economics theory.

Behavioural finance studies the psychology of financial decision-making. Most people know that emotions affect investment decisions. People in the industry commonly talk about the role greed and fear play in driving stock markets. Behavioural finance extends this analysis to the role of biases in decision making, such as the use of simple rules of thumb for making complex investment decisions. In other words, behavioural finance takes the insights of psychological research and applies them to financial decision- making.

Traditional vs. behavioural finance

Over the past fifty years established finance theory has assumed that investors have little difficulty making financial decisions and are well-informed, careful and consistent. The traditional theory holds that investors are not confused by how information is presented to them and not swayed by their emotions. But clearly reality does not match these assumptions.

Behavioural finance has been growing over the last twenty years specifically because of the observation that investors rarely behave according to the assumptions made in traditional finance theory.

Behavioural researchers have taken the view that finance theory should take account of observed human behaviour. They use research from psychology to develop an understanding of financial decision- making and create the discipline of behavioural finance. This guide summarises the findings of these ground-breaking financial theorists and researchers.

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Established financial theory focuses on the trade-off between risk and return. However, behavioural finance suggests investors are overconfident with respect to making gains and oversensitive to losses.

Research in psychology has documented a range 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. The biases relate to how we process information to reach decisions and the preferences we have.^1

The biases tend to sit deep within our psyche and may serve us well in certain circumstances. However, in investment they may lead us to unhelpful or even hurtful decisions. As a fundamental part of human nature, these biases affect all types of investors, both professional and private. However, if we understand them and their effects, we may be able to reduce their influence and learn to work around them.

A variety of documented biases arise in particular circumstances, some of which contradict others. The following sections discuss the key biases and their implications for investors and advisers.

How behavioural biases affect

investment behaviour

1 Shefrin, Hersh, 2000. Beyond Greed and Fear: Finance and the Psychology of Investing. Chapters 1-3.

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Overconfidence and investing

Overconfidence has direct applications in investment, which can be complex and involve forecasts of the future. Overconfident investors may overestimate their ability to identify winning investments. Traditional financial theory suggests holding diversified portfolios so that risk is not concentrated in any particular area. ‘Misguided conviction’ can weigh against this advice, with investors or their advisers ‘sure’ of the good prospects of a given investment, causing them to believe that diversification is therefore unnecessary.

Overconfidence is linked to the issue of control, with overconfident investors for example believing they exercise more control over their investments than they do. In one study, affluent investors reported that their own stock-picking skills were critical to portfolio performance. In reality, they were unduly optimistic about the performance of the shares they chose, and underestimated the effect of the overall market on their portfolio’s performance. 3 In this simple way, investors overestimate their own abilities and overlook broader factors influencing their investments.

Too much trading

Investors with too much confidence in their trading skill often trade too much, with a negative effect on their returns. Professors Brad Barber and Terry Odean studied US investors with retail brokerage accounts

Overconfidence

3 Werner De Bondt (1998), ‘A Portrait of the Individual Investor,’ European Economic Review.

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Advisers and overconfidence Advisers need to consider the potential for overconfidence in themselves and their clients. Clients can be counselled against trading too much. Advisers should consider carefully the outcomes of past investment decisions, making an honest assessment of what went well and what did not. Lessons can be learned for future decisions.

and found that more active traders earned the lowest returns. 4 The table shows the results for the most and least active traders. For the average investor switching from one stock to another, the stock bought underperformed the stock sold by approximately 3.0% over the following year. Whatever insight the traders think they have, they appear to be overestimating its value in investment decisions.

Portfolio turnover and return

Mean monthly turnover

Average annual portfolio return

20% least active traders 0.19% 18.5%

20% most active traders 21.49% 11.4%

Source: Brad Barber and Terrence Odean (1999) ‘The courage of misguided convictions’ Financial Analysts Journal, November/December, p. 50.

Skill and luck

Overconfidence may be fuelled by another characteristic known as ‘self-attribution bias’. In essence, this means that individuals faced with a positive outcome following a decision, will view that outcome as a reflection of their ability and skill. However, when faced with a negative outcome, this is attributed to bad luck or misfortune. This bias gets in the way of the feedback process by allowing decision- makers to block out negative feedback and the resulting opportunity to improve future decisions.

Overconfidence

4 Brad Barber and Terrence Odean (1999) ‘The courage of misguided convictions’ Financial Analysts Journal , November/December, pp 41-55.

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The idea of loss aversion also includes the finding 6 that people try to avoid locking in a loss. Consider an investment bought for £1,000, which rises quickly to £1,500. The investor would be tempted to sell it in order to lock-in the profit. In contrast, if the investment dropped to £500, the investor would tend to hold it to avoid locking in the loss. The idea of a loss is so painful that people tend to delay recognising it.

More generally, investors with losing positions show a strong desire to get back to break even. This means the investor shows highly risk-averse behaviour when facing a profit (selling and locking in the sure gain) and more risk tolerant or risk seeking behaviour when facing a loss (continuing to hold the investment and hoping its price rises again).^7

The disposition effect

Professors Shefrin and Statman developed the idea of loss aversion into a theory called the ‘disposition effect’, which indicates that individuals tend to sell winners and hold losers. In later research, Professors Barber and Odean tested this idea using data from a US retail brokerage. They found that investors were roughly 50% more likely to sell a winning position than a losing position, despite the fact that US tax regulations make it beneficial to defer locking in gains for as long as possible, while crystallising tax losses as early as possible. They also found that the tendency to sell winners and hold losers harmed investment returns.

Advisers and loss aversion Advisers have a key role in helping clients deal with loss aversion and contain their desire to sell winners and hold losing investments. The adviser can help the client evaluate whether the investment still has good future prospects and whether it is still suitable for the client’s circumstances.

Loss aversion

6 Barber and Odean (1999) p42. 7 Daniel Kahneman and Amos Tversky (1979) ‘Prospect Theory: An anaysis of decision making under risk’ Econometrica 47:2, pp. 263-291.

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The problem of inertia

Regret avoidance

Inertia means that people fail to get around to taking action, often even on things they want or have agreed to do. A related issue is a tendency for emotions to sway you from an agreed course of action – ‘having second thoughts’. The human desire to avoid regret drives these behaviours. Inertia can act as a barrier to effective financial planning, stopping people from saving and making necessary changes to their portfolios.

A fundamental uncertainty or confusion about how to proceed lies at the heart of inertia. For example, if an investor is considering making a change to their portfolio, but lacks certainty about the merits of taking action, the investor may decide to choose the most convenient path

• wait and see. In this pattern of behaviour, so common in many aspects of our daily lives, the tendency to procrastinate dominates financial decisions.

Overcoming inertia with an autopilot

In recent years behavioural researchers have designed ‘autopilot’ systems to counteract inertia.

For example, in the realm of retirement planning it has been observed that many individuals fail to join their company pension plan, possibly as a result of inertia. Changing the pension scheme so that employees are automatically enrolled in the scheme, while retaining a right to opt out, tends to boost take up rates considerably. In effect, the automatic enrolment approach puts inertia to a positive use. Automatic enrolment is planned for use in the UK’s new pension regulations, due to be implemented in 2012.

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Advisers and inertia Savings schemes, pound cost averaging and automatic portfolio rebalancing are autopilot approaches that can be used to help clients overcome inertia and meet their financial goals.

Autopilot approaches to investing

Autopilot approaches can also have relevance in investing, such as taking a disciplined approach to portfolio rebalancing, or a commitment to regular monthly savings. Such disciplined approaches – often called ‘commitment devices’ by behavioural economists – can help investors avoid biases like overconfidence and promote rational investor behaviour.

In terms of rebalancing, using a regular schedule for guiding decisions can help investors to avoid being swayed by current market conditions, recent performance of a ‘hot’ investment or other fads. It results in a regular strategy that sells out of markets or investments that have recently outperformed and adds to markets or investments that have lagged. Regular investing, the process of ‘pound cost averaging, also helps as the investor tends to accumulate more units or shares of an investment when markets are low than when they are high.

The problem of inertia

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Framing

Finance theory recommends we treat all of our investments as a single pool, or portfolio, and consider how the risks of each investment offset the risks of others within the portfolio. We’re supposed to think comprehensively about our wealth. Rather than focusing on individual securities or simply our financial assets, traditional financial theory believes that we consider our wealth comprehensively, including our house, company pensions, government benefits and our ability to produce income.

However, human beings tend to focus overwhelmingly on the behaviour of individual investments or securities. As a result, in reviewing portfolios investors tend to fret over the poor performance of a specific asset class or security or mutual fund. These ‘narrow’ frames tend to increase investor sensitivity to loss. By contrast, by evaluating investments and performance at the aggregate level, with a ‘wide’ frame, investors tend to exhibit a greater tendency to accept short-term losses and their effects.

Mental accounting

Our psychological self thinks about money and risk through ‘mental accounts’ – separating our wealth into various buckets or pools. We often base these pools on goals or time horizon (such as ‘retirement’ or ‘school fees’). Accounts can also vary in risk tolerance, investing some in risky assets for gain while treating others more conservatively.

Constructing portfolios

Advisers, framing and mental accounting Behavioural finance suggests that advisers could derive an advantage from developing an awareness and understanding of framing and mental accounting. The adviser could focus on the particular mental accounts the client has and the objectives and risk tolerance of each one. It may not be possible to establish a single overall tolerance for risk. Rather, the client may have a different risk tolerance for their pension, ISA and so on. Advisers should counsel clients to evaluate their financial assets with the widest ‘frame ‘ possible and avoid focusing on individual securities or instruments.

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This idea explains why an individual investor can simultaneously display risk-averse and risk-tolerant behaviour, depending on which mental account they’re thinking about. This model can help explain why individuals can buy at the same time both ‘insurance’ such as gilts and ‘lottery tickets’ such as a handful of small-cap stocks. The 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.

Constructing portfolios

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Advisers understand the critical importance of portfolio diversification. However, behavioural finance research suggests investors sometimes struggle to apply the concept in practice.

Naïve diversification

Evidence suggests that investors use ‘naïve’ rules of thumb for portfolio construction in the absence of better information. 9 One such rule has been dubbed the ‘1/n’ approach, where investors allocate equally to the range of available asset classes or funds (‘n’ stands for the number of options available). This approach ignores the specific risk-return characteristics of the investments and the relationships between them.

Investors might understand the importance of diversification, but not knowing exactly how to achieve it, go for a simple approach. The twist here is that despite the apparent behavioural bias, recent research has shown investors using naïve ‘1/n’ techniques can sometimes do better than the investors who construct portfolios using sophisticated computer models.^10

Managing diversification

9 Bernartzi, Shlomo and Richard H. Thaler. ‘Naive Diversification in Defined Contribution Savings Plans.’ American Economic Review 91(1), (2001): 79-98. 10 DeMiguel, V., L. Garlappi and R. Uppal, 2009, ‘Optimal versus Naive Diversification: How Inefficient is the 1/N Portfolio Strategy?’ The Review of Financial Studies 22.5, 1915-1953.

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Researchers have documented a number of biases in the way in which we filter and use information when making decisions.^11 In some cases, we use basic mental shortcuts to simplify decision-making in complex situations. Sometimes these shortcuts are helpful, in other cases they can mislead.

Anchoring

Decisions can be ‘anchored’ by the way information is presented. In a non-financial example, participants’ responses to questions with numerical answers, such as ‘How many countries are there in Africa?‘ were apparently affected by the value shown on a ‘wheel of fortune’ that was spun in front of them prior to answering. The wheel value provided an anchor that while irrelevant to the question still influenced the answers given.

In the financial sphere, values such as market index levels can act as anchors. Round numbers such as 5,000 points on the FTSE 100 Index, seem to attract disproportionate interest, despite them being numbers like any other.

Using – or misusing – information

11 Shefrin (2000) Chapters 1-3.

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Availability bias

Some evidence suggests that recently observed or experienced events strongly influence decisions. Psychologists refer to this as the ‘availability bias’. Researchers found that individuals were likely to overestimate the chances of being in a car crash if they had seen a car crash on a recent journey. The recent memory made the prospect more vivid – available – and therefore more likely. To give a financial example, investors are more likely to be fearful of a stock market crash when one has occurred in the recent past.

Representativeness bias

The notion of ‘representativeness bias’ reflects the case where decisions are made based on a situation’s superficial characteristics (what it looks like) rather than a detailed evaluation of the reality. Another way of putting this would be saying that decisions are made based on stereotypes. A common financial example is for investors to assume that shares in a high-profile, well-managed company will automatically be a good investment. This idea sounds reasonable, but ignores the possibility that the share price already reflects the quality of the company and thus future return prospects may be moderate. Another example would be assuming that the past performance of an investment is an indication of its future performance.

Using – or misusing – information