Preventing mistakes with behavioural finance

Mr. Silverman was upset during the 1999 client review meeting. He couldn’t fathom why you, his advisor, had not increased his equity allocation to take full advantage of the bull market in which his peers were participating. You were reminded of that meeting during the 2009 review when Mr. Silverman declared that he “had enough” and “couldn’t take it anymore.” He felt he was over-exposed to equities in the first place.

All advisors have faced a situation where a client wants to change the strategic asset allocation of a portfolio during a period of great market stress. Behavioural finance allows advisors to better understand client behaviour and improve communication strategies in order to avoid poor decision-making and deepen client relationships.

Research in this field has taken two broad tracks: the application of social psychology to financial decision-making, and neuroscience research, which studies biological reactions to making a profit, suffering a loss, confirming an expectation or experiencing a surprise.

Behavioural finance is often viewed as a rejection of investment models and applications promoted by classical economics. An alternative view is that behavioural finance picks up where traditional financial models leave off. While the goal is not to solve the puzzles of finance, it is useful to consider both approaches in formulating investment plans and dealing with market stress.

Types of behavioural biases

Behavioural finance identifies and explains biases that detract from our ability to make rational economic decisions. Awareness of these human biases can help an advisor better understand a client’s decision-making, and is an important step toward developing solutions that meet clients’ needs. It is useful to group behavioural biases into two broad categories: cognitive and emotional biases.

Cognitive biases are challenges in correctly processing information. An example of an investment-related cognitive bias is when investors are overconfident in a judgment about the future and place undue importance on past investment outcomes. This is a big issue for clients and advisors alike. Human minds like to see trends, even amidst randomness. The ability to deduce trends was helpful, if not crucial, for our evolutionary development as a species, but it does not serve us well as investors.

Emotional biases relate to the excessive influence of emotion on our decision-making. While humans cannot make completely emotionless decisions, advisors can focus on areas where emotions control rather than support client decisions. There are many factors, such as short-term thinking and herding, that may influence investment decisions negatively, but one of the most significant is loss aversion.

The importance of loss aversion

Loss aversion is an emotional bias. Research shows investors feel the pain of even small losses significantly more than the pleasure of equal, or even larger, gains. It is different from the classical economics idea of risk aversion in that the emotional impact of small losses is disproportionately larger than the impact of big losses. In fact, researchers have generally concluded that small losses hurt about 2.5 times more than a similar-sized gain brings pleasure.

This phenomenon leads to at least two behavioural patterns. First, although clients do not want to take a chance on getting rich, they tend to take chances to avoid becoming poor. You might demonstrate this with the following exercise: Ask your clients to imagine they just received a $1,000 fine for a traffic infraction. They may either pay the fine outright or enter an amnesty lottery where they have a 50% chance of having the fine waived or a 50% chance having it doubled to $2,000.

Nobel Prize winner Daniel Kahneman showed that most people would tend to enter the lottery to avoid paying the fine. These same people would opt for the sure thing if they won a lottery that offered them either $1,000 or a chance to go double or nothing on the flip of a coin. Harold Evensky outlines a series of exercises that advisors can work through with clients to illustrate their vulnerability to behavioural biases in his book with the CFA Institute, The New Wealth Management, to be published in spring 2011.

Another implication of loss aversion is that it prevents individuals from selling poor investments, even when significant evidence shows there is no prospect for improvement in their holdings. Researchers have found that under emotional distress, individuals often favour high payoff and reward choices, even if they are poor decisions.

The displeasure of realizing a loss by selling is so great that often the solution is to hold on in hopes the investment will turn around. In his upcoming book, Evensky argues that framing techniques are one of the most powerful tools in the advisor’s repertoire. Rather than evaluating gains and losses relative to a reference point—where they first entered into the trade—advisors can focus attention on the investment value of alternative investment options and their relevance to a client’s financial goals. For example, if you were offered a candy bar, would you prefer the one that is 10% fat or the one that is 90% fat-free?

Herding: Innate bias?

Another common investment challenge is herding behaviour, which is powerful in both individual and institutional investors. The pain of social exclusion for most clients is too great to bear, so the need to own the flavour of the day wins, whether it is Internet stocks, gold or bonds. Even if these investments have poor returns, investors take solace in knowing they were not alone. Misery loves company.

Evidence for this behaviour can be found in mutual fund flows and incidences of headline news articles about a particular investment. In fact, the March/April 2007 issue of Financial Analysts Journal published an article titled, “Are Cover Stories Effective Contrarian Indicators?” that demonstrated positive cover stories from Bloomberg Businessweek, Fortune and Forbes generally indicate the end of the featured company’s superior performance.

Investors following contrarian investment strategies, such as value investing, invite social pain and can feel like the herd is trampling them. Herding behaviour is difficult to overcome, partly because it appears to be hard-wired into human brains. In The New Wealth Management, Evensky again recommends framing. When a client proposes getting in on the next hot investment trend, the advisor’s response might be, “If you are right, you make a handsome profit. If you are wrong, you will need to work another three years.” What can be done for clients? Behavioural finance observes many departures from rationality, and neuroscience has given our profession some remarkable scientific evidence of how human brains work in response to investing pleasure, pain and other emotions. What other strategies can advisors use to deal with these issues in client relationships?

Sophisticated personality tests have been developed to categorize individuals based on their strongest behavioural traits. These tests are more complete and possibly more useful than traditional risk tolerance questionnaires. The results of these tests can yield strategies for dealing with clients with a myriad of behavioural traits.

In Behavioral Finance and Wealth Management, Michael Pompian identifies eight investor personality types and their biases. Pompian argues that once the investor types have been defined, the advisor can create an asset allocation designed to mitigate the biases. However, categorizing an investor as Type X is only partially valid since that client behaviour can be situational—for example, a conservative investor can become risk-seeking if put in the appropriate circumstances.

Much like classical investment theory, behavioural finance does not have all the answers. It is, however, extremely helpful in developing functional, long-lasting client relationships that help a client—as well as his or her advisor—avoid common and predictable investing mistakes.

Stephen Horan, PHD, CFA, is head of Professional Education Content and Private Wealth for the CFA Institute.