Behavioural Finance: Investor Biases
For this week’s edition of the PIO, we revisit the topic of behavioural finance. To reiterate, the study of behavioural finance takes the insights of psychological research and applies them to financial decision making. The field assumes humans are irrational. We want to identify areas where our emotions can impact financial decisions. Once acknowledged, we can moderate behaviour to improve economic outcomes and life satisfaction. Individuals often act on emotional and cognitive biases. A bias can be thought of as a preference or an inclination. In this write up, we highlight three common behavioural biases: overconfidence, status quo, and loss aversion.
Overconfidence: Overconfidence can be defined as unwarranted belief in one’s intuitive reasoning, judgements, and cognitive skills. It refers to the concept that people tend to overestimate their abilities. It takes humility to admit that you are just as susceptible to making poor decisions as the next person. On the other hand, overconfidence can be beneficial. It can assist in the process of bouncing back from a setback and grants us a more positive outlook of the world.
Example: If you were asked to assess your driving ability in relation to other drivers, you would probably rank yourself above average. Ola Svenson (1981) found most people regard themselves as better drivers than others, an impossible statistic.
Status Quo (Inertia) As the law of inertia states, “things at rest like to stay at rest”, this can be applied to many things, including investor decision-making. We have a preference to remain in our current state and not take action to change, despite better possible outcomes. While focusing on investments you understand and are comfortable with is not a bad approach, it may limit your potential.
Example: More people will participate in a company benefit plan if it is opt-out compared to opt-in.
Loss Aversion Loss aversion is another emotional bias. The bias states that people generally feel a stronger impulse to avoid losses than to acquire gains. According to Daniel Kahneman and Amos Tversky (1979), the possibility of a loss is, on average, twice as powerful a motivator as the possibility of making a gain of equal size. This fear of loss can lead to sub-optimal decisions.
Example: The pain of losing $100 is often far greater than the joy of gaining $100
“This means that” it is important to recognize that generally, individuals act irrationally. Being aware of different influences on financial decision-making is the first step to mitigating negative potential consequences. Once identified, awareness of biases could help achieve financial goals.
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*All returns are time weighted and net of investment management fees. Returns from the Pathfinder Partners’ Fund and Partners’ Real Return Plus Fund are presented based on the masters series of each fund. The Pathfinder Core: Equity Portfolio and The Pathfinder Core: High Income Portfolio are live accounts. These are actual accounts owned by the Pathfinder Chairman (Equity) and client (High Income) which contain no legacy positions, cash flows or other Pathfinder investment mandates or products. Monthly inception dates for each fund and portfolio are as follows: Pathfinder Core: Equity Portfolio (January 2011), Pathfinder Core: High Income Portfolio (October 2012) Partners’ Fund (April 2011), Partners’ Real Return Plus Fund (April, 2013), and Partners’ Core Plus Fund (November 2014).
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