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What’s Behavioral Finance?

Investors often fail to understand how their own biases and emotions can play into investment decisions, and can end up missing out as a result. Take the time to learn about your biases and how behavioral finance works, so to you can talk through a plan that will keep you invested in solid holdings, even when times get tough.

There’s a lot of research, analysis, advice and discussion that can go into deciding what stocks and other products to invest in, but all too often investors fail to take one of the most fundamental aspects of investing into account: themselves.

While many would like to believe their investment choices are rational and well-thought out, all too often people push the panic button prematurely and miss out on a good return because their emotions get in the way. It’s a phenomenon experts call behavioral finance.

“People dismiss it because it’s emotional and they view investment as extremely practical, fundamental and number-driven, and in reality, what we find as advisors, is investor behavior is by far the biggest single contributor to an investor’s ability to lose money,” said Peter McGann, wealth advisor at McGann Wealth Management in Ottawa.

“We believe that upwards of 70 per cent of your losses could be attributed to you making the wrong decision to sell or trying to time the market as to when to buy – typically, if investors are left on their own, they will sell at the bottom and buy at the top.”

In 2008, for instance, when the banks were down over 50 per cent some investors sold those holdings because they couldn’t cope with looking at their statements, but within 18 months, those stocks were right back up to where they had dropped from.

Experts agree that the first step towards avoiding these types of mistakes is to understand yourself and your biases.


behavioral-finance-2

“In a study done by a group of psychologist at Florida State, they found that allocation of energetic resources during emergencies follows a last in, first out rule according to which mental abilities that developed last in our evolutionary history, abilities like self-control are the first to be rationed when our glucose reserves are low.”

“Evidence of Gut Feeling – The Vagus Nerve plays a central role in the production of what we believe to be gut feeling. Vagus – Greek for wanderer, influences the tissues and organs that it touches by exerting a calming effect. Almost 80% of the vagus nerve carries information from the body to the brain, affecting our thoughts, emotions and moods.”

Source: Hour Between Dog And Wolf

Those can make up a fairly large list, but according to Robert Stammers, director of investor education for the CFA Institute, the most common biases that lead to investor mistakes include:

  1. Overconfidence: People who are very confident about their decision-making abilities sometimes extend this to the stock market, taking more risk than they should because they feel they’re so good at making decisions that they can’t go wrong.
  2. Negativity Bias: On the flipside, those who’ve had a negative experience in the past – they either lost a lot of money or suffered through a period of high volatility – may be too scared to take risks, and so they take too little. This plays into the concept of “reducing the regret,” where investors will hold on to stocks that lost money instead of selling them and buying something better because they hope the stock will make money again and make them feel better about their loss.
  3. Chasing Trends or Herd Mentality: This bias relates to the fact that people tend to buy stocks that performed well in the recent past, whether it was the best fund from last year, or the newest idea. People will buy these because they expect them to continue to do well or because lots of people are investing in them.
  4. Bonded Rationality: People have a limited attention span, and many will make decisions with limited information. This can lead to trouble if people don’t do enough due diligence or fail to regularly review their investments, and instead make a lot of investment decisions with a limited amount of knowledge.
  5. Anchoring: This bias suggests that investors will expect something to happen because they’ve seen it in the past or because they believe it to be a rule of thumb.

A bit of introspection can make a big difference when it comes to these investment biases, and understanding the emotional and cognitive biases that affect us can be the best way to try to avoid them – or to at least lessen their effect on our decision making, Stammers added.

It’s also a good idea to try to make investment decisions as procedural and process-oriented as possible.

“When you buy a certain security, write down the rationale for why you bought that security, or how does it fit into your investment plan,” Stammers said.

“You’re less likely to modify your existing strategy or divest of a security simply because it’s not performing well in the current period because there was a rationale and a process for having bought it in the past.”

McGann also suggests taking investors through a “fire drill” where you simulate what their portfolio would look like if it were to go down 25 per cent, explaining what the plan would be if and when that actually happens.

“When times get tough and clients feel like they are forced to make a decision, (if) the only thing they can look at is their statements or the stock market, they will make the wrong decisions based on headlines and media,” said McGann.

“You become a lemming and you will follow the lemmings, and history shows that the investors that make the most money go in the opposite direction to the lemmings.”

If you aren’t able to work with a wealth or investment advisor, Stammers suggests teaming up with a friend, so that you can talk through your decisions and remind each other of the reasons you made those choices when one of you starts to panic. That way you may be able to avoid the trappings of behavioral finance.

“Everyone is going to go through a period where either the market drops considerably or the markets get very volatile, but that’s something they should expect,” Stammers said.

“But if you’ve done your analysis of yourself correctly and you understand how much risk – not just financially but emotionally – you can take, you should be able to build a portfolio that won’t keep you up at night regardless of what’s happening in the market.”

Bill-Ackman “I have often stated that in order to be a great investor one needs to first have the confidence to invest without perfect information at a time when others are highly skeptical about the opportunity you are pursuing. This confidence, however, has to be carefully balanced by the humility to recognize when you are wrong.” – Bill Ackman


51zjbmLdT0L._UX250_“Few people have absorbed the hard neuroscience research that reasons arrive afterwards. That given the choice between a simple, easy-to-understand explanation that works and a difficult one that doesn’t, people tend to pick the latter. People would rather have any story about a series of price changes happened than that there is no rational reason for it. Confusing hindsight with foresight and complexity with insight are a few more ‘cognitive illusions’ of Behavioral Finance.” – Charles Faulkner

2 years ago

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