Behavioural Investing

Why do we do what we do?

May 18, 2017

This is the first in series of blogs about a compelling financial issue.

It’s a tough question to answer. Unthinking behaviour can, and very often does, lead to unpleasant consequences. Misunderstanding. Regret. Loss. These are just three of the results of unthinking behaviour. But what happens when unthinking behaviour influences investment decision-making?

The subject of ‘behavioural investing’ – an understanding of the human biases that can often influence a client’s investment choices – is one that has challenged experts for years. Morningstar Inc., a global provider of independent investment research, published an article as part of its May 2016 Risk Management Boot Camp called Don’t Get Caught By These 10 Behavioural Pitfalls. It’s makes fascinating reading, summarized here:

  1. Overconfidence
    Studies show that overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade. Trading rapidly can be expensive, and rarely rewards the effort. Trading costs in the form of fees (ours are modest and transparent), taxes, and losses on the bid-ask spread are a serious damper on annualized returns.
  2. Selective Memory
    Few of us want to remember a painful event or experience in the past, particularly one that was of our own doing. In terms of investments, we certainly don’t want to remember those stock calls that we missed, much less those that proved to be mistakes that ended in losses.
  3. Self-Handicapping
    This bias occurs when we try to explain any possible future poor performance with a reason that may or may not be true. As investors, we may also succumb to self-handicapping, perhaps by admitting that we didn’t spend as much time researching a stock as we normally had done in the past, just in case the investment doesn’t turn out quite as well as expected.
  4. Loss Aversion
    This happens when investors feel the pain of even small losses significantly more than the pleasure of equal, or even larger, gains. It’s no secret, for example, that many investors will focus obsessively on one investment that’s losing money, even if the rest of their portfolio is in the black. This is loss aversion. Try to avoid it.
  5. Sunk Costs
    Another factor driving loss aversion is the sunk-cost fallacy. This theory states that we are unable to ignore the ‘sunk costs’ of a decision, even when those costs are unlikely to be recovered. Sunk costs may prompt us to hold on to a stock even as the underlying business falters, rather than cutting our losses.
  6. Anchoring
    Investors get anchored on their own estimates of a company’s earnings, or on last year’s earnings. Anchoring behaviour manifests itself in placing undue emphasis on recent performance, since this may be what instigated the investment decision in the first place. Don’t hold on to losers.
  7. Confirmation Bias
    This is about treating information that supports what we already believe, or want to believe, more favorably. For example, knowing the outcome of a stock’s performance, we may adjust our reasoning for purchasing it in the first place. This type of ‘knowledge updating’ can keep us from viewing past decisions as objectively as we should.
  8. Mental Accounting
    Mental accounting is when we categorize our funds without looking at the bigger picture. While we might diligently place any extra money left over from our regular income into savings, we often view tax refunds a ‘found money’ to be spent more frivolously. In investing, money is money, no matter whether the funds in a brokerage account are derived from savings, an inheritance, capital gains, or a tax refund.
  9. Framing Effect
    This is another form of mental accounting. The framing effect addresses how a reference point, oftentimes a meaningless benchmark, can affect our decision. The best way to avoid the negative aspects of mental accounting is to concentrate on the total return of your investments.
  10. Herding
    The pain of social exclusion is, for many clients, too great to bear, so the need to own the investment flavour of the day prevails, win or lose. In many cases a stock has come to the public’s attention because of its strong previous performance, not because of an improvement in the underlying business. Following a stock tip under the assumption that others have more information is a form of herding behaviour.

At The Wooding Group, part of our job is to help our clients recognize, and avoid, these deceptive behavioural biases. That doesn’t mean we’re psychiatrists, but we are watchful.

In our world, logic and rationality transcend emotion every time.

The Wooding Group at CIBC Wood Gundy, 780-498-5047