Behavioural Finance

The investment world is based on decisions humans make regarding money every day – some decisions lead to positive outcomes, and others have negative results.

Consider this scenario: two avid sports fans in rural Alberta plan to travel 100 kilometres to Edmonton to see a hockey game. One fan has paid for his ticket, the other received a free ticket from his friend. Five hours before puck drop, an extreme blizzard commences. Which of the two ticket holders is more likely to brave the blizzard to see the game?

The fan who paid for the ticket is more likely to drive. Both fans set up a Mental Account for the game they hoped to see. Missing the game will close the accounts with a negative balance, but the balance is distinctly more negative for the fan who bought the ticket and is now out of pocket.

For example, let’s take Sonya, a professional architect and 45-year-old mother of three. She receives a $3,000 tax refund and places this in a mental account of “found money.” She’s more likely to spend the $3,000 on a tropical vacation rather than reinvesting it in her TFSA. This concept has a specific term associated with it, called Mental Accounting – where people value money differently based on its source, causing one to separate money into different categories.

You may ask, what am I getting at here? Well, the concept of mental accounting is part of the fascinating and dynamic field of Behavioural Finance. This field has gained much attention in the past decade and is likely to dominate conversation in the years to come. As humans, we make decisions every day about our money, but why do we make specific decisions in certain situations? This is behavioural finance at work.

So what is behavioural finance and can it be used to make better investment and financial decisions? Behavioural finance is the study of the influence of psychology on the behaviour of investors. It also includes subsequent effects on the markets. It focuses on the fact that investors are not always rational, have limits to their self-control, and are influenced by their own biases. Traditional finance includes the following beliefs: both the market and investors are perfectly rational, investors truly care about utilitarian characteristics, and they are not confused by cognitive or information processing errors. Behavioural finance tries to understand why people make the decisions they do.

There are many practical uses for behavioural finance. We believe there is valuable insight one could gain from learning about behavioural finance, and by understanding and applying the concepts, we can become better advisors.

Behavioural finance states that humans make mistakes when it comes to investing. These mistakes are sub-classified into two types of biases: cognitive and emotional.

Cognitive Errors are the “blind spots” in the human brain driven by mistakes made in how we process information, and by our own experience and memories. Here is a specific example: suppose you and your family are considering a long trip across the world, which involves airline travel. There is a devastating plane crash five days before your trip that attracts international media attention, and you have been glued to the television coverage since the tragedy occurred. This dramatic event will now temporarily alter your feelings about the safety of flying. This illustrates the Availability Bias – which is the process of judging frequency by the ease that instances come to mind. In this example, our decision-making process is most strongly influenced by events closest and most available to us. This concept is also quite prevalent in finance, and a recent example is the 2019 US-China Trade War. Tariffs were slapped on, and exchanges of angry tweets and threats followed, which led to market uncertainty and a minor sell-off of banking stocks in Singapore. Share prices of DBS Group Holdings Ltd. (DBS), Oversea-Chinese Banking Corp. (OCBC), and United Overseas Bank Ltd. (UOB) tumbled down, only to see them bounce back up quickly after a few days.

Emotional Biases are biases that arise from intuition and impulse where decisions are highly influenced by feelings. Take Loss Aversion – which seeks to explain that, as humans, we value losses higher than we value gains. We also tend to avoid losses rather than to seek out gains. Loss aversion can be simply explained in the following example. Take these two decisions:

A. Guarantee to lose $2,000
B. 50% chance to lose $4,000 and 50% chance to lose $0

In the realm of investing, investors have the tendency to realize paper gains more quickly, but delay or even avoid realizing paper losses. They tend to hold onto the losers and sell the winners, as investors want the losers to break even before considering selling. We are willing to take additional risks to lose more or lose nothing.

The examples I’ve shared are just a sample of some cognitive and emotional errors. There are many more intriguing biases that would be too much to explore in this one article. As humans, we are hard-wired to make the decisions we make because of our own unique life experiences. Having the understanding and knowledge that cognitive and emotional biases exist may help us make better financial and investment decisions. As a financial advisor, I like to ask many questions to truly understand what my clients are trying to achieve, and why they have made specific choices about money. Ultimately, this helps me understand more about the entire picture and enables me to provide the best possible advice for my clients.

If you want to discuss behavioural finance in more detail, please consult with your RGF advisor. ■