“Great investors are those who are generally less affected by cognitive bias than the general population, learn about biases and how to cope with them, and put themselves in a work environment that allows them to think well.”
— Thorsten Hens and Anna Meier of Behavioral Finance Solutions
BEHAVIORAL FINANCE • INVESTING • DECISION MAKING
Why is behavioral finance so important?
A subject that has been broached and become more mainstream over the last decade has been that behavioral finance has a large impact in how investors make decisions. However, for most investors and investment processes, the subject continues to hang on the outskirts and is not readily implemented or observed. This paper hopes to shine a brighter light on something that should be an aspect of every eventual investment decision, not to be all encompassing or to cause inertia, but to reduce behavioral errors that can have major implications on your portfolio and financial goals.
This blog will first and foremost discuss what behavioral bias look like in investors, while also extrapolating on ways to mitigate this bias in order to provide better investment outcomes. The ultimate goals that I hope this blog will instill in investors is first a recognition of your own bias and those of investors in which we have allocated financial resources too, and; secondly, being cognizant of the mistakes made as a result of these biases and taking judicious steps to avoid them in the future.
Traditional Finance Theory and the Evolution of Prospect
Theory
Traditional finance theory has been based on utility theory, where investors are risk averse and feel diminishing marginal utilities of wealth (i.e. as wealth increases, they are less likely to take risk). Unfortunately, utility theory is based on unrealistic expectations such as:
While these were used to for simplicity reasons, they were not able to be as practically implemented in investment processes. This led academics, mostly psychologists, to review specific and observable investor behaviors that persist over time which came to be known as behavioral finance.
Academics Daniel Kahneman and Amos Tversky’s were not satisfied with the practicality of utility theory, and instead proposed Prospect Theory, which postulated that the significance of investor losses has the greatest impact on the utility perceived by investors. Basic assumptions of Prospect Theory include:
The result is that prospect theory assumes investors are risk averse when facing gains (and therefore sell winners too soon) but loss averse and risk seeking when facing losses (and therefore hold losers too long). This is also called disposition affect and it can have massive negative implications on the portfolio returns over time. As an example, it is often that “deep value” managers made a wrong determination about a stock and its future prospects, but continue to hold it in order to not face the realization that something they did was wrong. Most of the time this means changing the underlying thesis to present a rosier picture of a company’s prospects and ability to get out of the rut they are currently in.
Herbert Simon proposed Bounded Rationality as “the idea that when individuals make decisions, their rationality is limited by the available information, the tractability of the decision problem, the cognitive limitations of their minds, and the time available to make the decision”. Essentially, we are not machines and have limitations on the amount of data we are able to process at any one point in time. We are also shaped by experiences and are not necessarily always rational. This leads to the process of satisficing or accepting the most satisfactory option based on the data we have been able to process and our prior experiences.
Behavioral Finance Basics
Behavioral finance is the process of reviewing how cognitive limits and emotional bias affect us as investors. The goal is to make sure that we have a strong understanding of how these will affect us so as to have the highest probability of investment success and not making significant and irreversible financial mistakes.
Behavioral finance assumes investors exhibit three other major characteristics which are loss aversion, biased expectations and they construct portfolios via asset segregation (bucketing investments into certain areas instead of looking at the portfolio as a whole). We will discuss each below, but in general, individual investors overestimate their ability to forecast the future. This overestimation isn’t just relegated to the world of personal finance, but most people overestimate their abilities in multi-facets of life: 75% of employees believe they are above average, which as you can see is an impossibility. Relatively the same statistic applies to people who believe they are better drivers even when their traffic and accident record say differently.
The most common behavioral finance mistakes are below and fall into the category of belief perseverance:
Cognitive errors are patterns of thinking that distort how we approach a subject or decision. Try to diligently review and recognize your own cognitive errors in order that we may not fall victim to them in the long-term pursuit of your financial goals.
A brief list of the most common cognitive errors that we look to identify are as follows:
Emotional errors are a result of the tendencies and preferences you have built over time. Think of it as your “gut reaction” to a problem. This is embedded in you and as such is actually the hardest to recognize and change.
A brief list of the most common emotional bias include:
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