When an investor buys or sells a security, is that decision based on a knowledge of all the relevant information about that asset? Probably not. Most financial decisions are made based on irrational or insufficient analysis of data, thus leading to irrationality. Irrationality is a product of our own behavioural bias.
Behavioural Finance combines behavioural and cognitive psychology theory with conventional economics and finance theories to provide explanations for why people make irrational financial decisions. The benefit of behavioural finance is that investors are able to recognize these behavioural biases and take corrective actions to avoid financial losses.
I have selected just a sample of some behavioural bias:
- Trend Chasing
- Loss Aversion
Anchoring: An Anchor bias is any variable of information which has no direct relevance to a decision but does affect financial decision making. In essence, a bit of information becomes “anchored” in our minds and thus automates our decision making.
An anchor can establish a low price bias to encourage a purchase decision or establish a higher price to lock in future purchases on that price. For example, a phone is listed at N20,000 but the shop puts up a “10% Sale” sign beside the price, effectively “reducing the price to N18,000. The buyer, however, anchors in his mind that the phone costs N20,000 not N18,000, he assumes an N2000 “discount” and pays for it. If given a choice between this phone and a similar model costing 18,000, a buyer may select his phone believing a deal of N2,000 for an N20,000 phone.
Another excellent example is when a stock priced at N50.00 falls to N20.00. An investor, having anchored the previous N50 share price in his mind, will determine that N20 is a “cheap” price and invest in that stock.
Key lessons: Do careful intrinsic evaluations before investing. For the entrepreneur, Be careful when setting prices. If your “special” pepper-soup, for instance, is N2,000 per plate, that’s the anchor. Customers will be wary about paying above that prices for any other dish in your restaurant.
Herding: Herding Bias is the tendency for individuals to copy and follow the actions (rational or irrational) of a larger group.
Imagine you go to a party and everyone is talking about this cryptocurrency fund they have just invested in. You are normally risk-averse, but you reason in your mind that if so many people are investing in this cryptocurrency, they all cannot be wrong. Consequently, you take comfort in the “safety” of crowds and also invest.
With herding, any form of appraisal is blurred by the tendency to follow the crowd, and not be left out of the latest investment trend. In other words, herding diminishes analytical reasoning, and that is the danger.
Key lessons: Study each investment carefully on its own merits and always remember every investor has different levels of risk acceptance. Referrals are just that…referrals to you. Ensure you do your own due diligence all the time. If everyone speaks highly of a vendor, have your own in-house assessment to confirm if the internal process of that vendor is aligned with your organization. Do not just hire an Insurance company because everyone in your industry uses them; have your own internal decision-making process to select vendors.
Familiarity: Familiarity bias is when an investor has become familiar with the operations and/or returns associated with a particular asset class, develops a comfort zone around that asset class, and is then reluctant to try other asset classes even though they may offer higher returns or reduce the overall risk of the portfolio. Here is an example; an investor may only be aware of investing in two-year Corporate Bond which he rolls over continuously after earning interest. Coupon bonds become his investment comfort zone and he is reluctant to invest in a security that pays zero interest such as a zero coupon bond, even though that security with no coupon payments is less susceptible to interest rate movements, thus less risky.
Key Lessons: Invest with a goal in mind. If your investment goal is clear and properly communicated, then follow the guidance and advise of an investment professional. Scenario planning, explore multiple options on paper, to see the effects of each action, before taking a decision.
Trend-chasing: This is when investors look at the past performance of a security or company in order to make a decision today whether they should invest.
In the world of investing, the common maxim is “Past performance is not a guarantee of future performance”. A fund may return 40% in year 1, even as a 43% return in year 2 does not mean it will even break even in year three.
Trend-chasing is a very common bias because investment firm will advertise their past performance to attract prospective new investors. Even if the investment firm is honest and competent and really wants to deliver above-average returns, the fact that other investment firms will copy a winning strategy means the impact of that winning strategy will be greatly diminished.
Key Lesson: When evaluating investments or investment firms, employ quantitative and non-quantitative measurements. Take past performance into account, but do not base decisions solely on that factor. Look at every investment on its merits, not its antecedents. Past performance and prices are not a sufficient indication of future performance or prices.
Loss Aversion: Loss aversion bias is when an investor has an aversion to making or admitting they have made a loss on an investment.
Investors have a high degree of confidence in their ability to pick investments and do not want to admit that sometimes they picked the wrong horse. The direct implication is that investors hold onto a bad investment, because selling that investment will acknowledge to themselves, they made a mistake.
For example, MMM, the failed Ponzi scheme, attracted a lot of deposits. Some “investors” may have run the numbers and determined the scheme was unsustainable. Yet, they still did not exit the scheme. Another example is Bitcoin; as the prices crashed, many held on to their cryptocurrencies unwilling to admit they have bought at the peak of the curve.
Key Lesson: The way to avoid loss aversion is to have a clearly defined exit strategy. Be clear on what will trigger a sale from your portfolio. Also, do extensive research before investing
Summary: It is important to recognize that investors are humans and bias will always seep into all decision making; including financial decisions. The way to avoid bias, however, is to have a plan/strategy to invest and manage a portfolio, including agreeing to an asset allocation strategy and retaining a competent financial adviser.
Artificial intelligence financial programmes are also helpful in stripping away bias.