From an academic point of view, much of the traditional economic and financial theory assumes that markets are efficient, whereby all individuals are rational people, considering all available information when taking a decision. However, we all know that is far from the truth, and behavioural finance has over the years taught us the importance of understanding how the psychological behaviour of individuals essentially play a very important role in influencing market outcomes and returns – macro impact.

However, in the next few paragraphs, I would like to highlight the importance of understanding certain behavioural traits from a micro level. That is, the understanding of individuals’ behavioural biases and how such behaviour differentiates from the rational decision makers of traditional finance. From experience, it is also true that when managing investors’ portfolios, such behavioural biases need to be embraced and addressed when constructing and rebalancing portfolios over time.

The truth of the matter is that when it comes to taking an investment decision, much of the time individual investors are faced with an abundant amount of information which they either do not have the ability to process, or perhaps lack the adequate knowledge to properly absorb and subsequently take a rational decision. As such, most of the time individuals end up settling for a sub-optimal answer, which may be rather subjective, and hence leading to irrational behaviours and decisions.

It is therefore essential for investment professionals to understand what type of behavioural biases exist such as to at least be able to mitigate the consequences such biases may have and try ameliorating the outcomes to be expected. And such behavioural biases could be easily exhibited by both the clients as well as the investment professionals themselves.

Broadly speaking, biases can be split into two broad categories. On one side, there are those biases relating to the way us humans think and process things in our mind, known as cognitive biases. On the other hand, biases influenced by feeling or some form of emotional attachment are known as emotional biases.

In practice, it is usually easier to address and correct for cognitive errors, which tend to result from faulty reasoning, relating to basic statistical or information-processing errors. In fact, cognitive errors can be further sub-divided into two. Belief perseverance type of biases essentially relate to the difficulty for an individual to interpret new information which conflicts with previously held beliefs or understanding. For instance, attaining new, perhaps material, information on a particular bond or equity, but failing to adequately reflect such new information in your views; better known as conservatism bias, where more weight is usually attached to the original beliefs, despite having come across new information.

A slightly different type of bias one tends to come across is known as confirmation bias, whereby people end up inadequately giving weight to news and information which confirms their beliefs, while at the same time ignoring or undervaluing information that contradicts their views. In practice, we come across this when investors for example take only into account positive information about a particular investment they hold, while ignoring any negative information that flows in on the same investment.

Representativeness bias is another form of cognitive error and a belief perseverance bias, whereby people tend to inappropriately classify new information based on past experiences and categorisation of information. In essence, an individual would try to “approximately” interpret information on a company or investment based on similar past experiences or sequence of events.

Two other common biases are illusion of control bias and hindsight bias. The former exists when individuals believe to have some form of control on an outcome, assigning undue weight towards the probability of personal success than warranted from an objective point of view. In layman’s terms, it is just the same as believing of achieving a higher probability of success when choosing lottery numbers yourself, as opposed to have them randomly generated. In the context of portfolio management, such bias could lead to excess trading leading to lower realised returns, and inadequately diversified portfolios.

Hindsight bias on the contrary is the tendency of people looking to the past as a predictable and outcome to expect. This would be easily avoided if one has an eidetic memory. However, given that most of us do not, when looking back, people tend to fill in the gap with whatever is easiest and believe preference – ending up not learning from the past.

Another set of cognitive-related biases have more to do with the processing of information, such as anchoring and adjustment bias whereby individuals refrain or fail to properly adjust estimates and probabilities of events happening on a particular security despite being faced with new information. The “anchor” in such scenarios would be the originally calculated earnings estimate or some initial purchase price level which an individual ends up tied too irrationally.

Other times, mental accounting bias entails people categorising sums of money into different buckets based on which mental account the money falls part of. However, rationally speaking, viewing portfolios (or one’s pool of assets) in a holistic, risk/return manner is deemed to be more effective, ideally taking into account the correlation dynamics across different assets within a portfolio as opposed to viewing different pools of assets as buckets in isolation.

Sometimes, even the way certain information is provided could have an impact on the way it is interpreted by the receiver, which in turn would result into different preferences and assumptions. This is known as framing bias. Example, a 30% success rate could be easily interpreted much more positively than otherwise statement stating a 70% probability of not reaching your goal.

Easily recalling the most recent information or the most readily made available information also has its consequences on one’s decisions. Availability bias is sort of a mental shortcut in taking an investment decision based on how easily information is made available and processed. However, this does obviously not mean that it is the most rational decision to take – biases which exists in our memories, and sometimes difficult to do without or avoid completely.

What is rather more difficult to adjust for and address are the emotional kind of biases. Emotions tend to have a more ambiguous impact as to how people arrive to certain conclusions and decisions. One very common emotional trait which I personally come across with when reviewing clients’ portfolios is loss-aversion – the tendency of people trying to avoid losses as compared to achieving gains. Such bias is normally reflected in an individual’s portfolio avoiding selling investments that have experienced losses too long, while selling securities which have gained in value too soon. This effectively could result into riskier portfolios, with a higher weighting towards securities considered to be “losers” and few “winners”.

Over-confidence when it comes to decision making and self-control, whereby individuals many times fail to maintain some form of self-discipline, are two biases that also warrant some attention. They can be both lead up to portfolios which are inadequately diversified, risky and costly as a result of excessive trading sometimes too.

On the contrary, not taking action on certain securities because of some form of emotional attachment, or simply because they tend to feel more comfortable with the way things are can also become challenging to address – sometimes referred to as status-quo or regret-aversion biases. It is also true that people tend to value an asset more when they own it as opposed to when they do not (Endowment bias). This is also often the case with inherited portfolios, experiencing some form of reluctancy by investors from making changes deemed necessary to adjust for their different risk profile and investment objective because of such emotional biases.

When it comes to managing peoples’ wealth, such behavioural biases highlighted above, whether of a cognitive or emotional kind, should be given due importance, and adequately highlighted and accounted for when developing a client’s investment policy statement and asset allocation selection process. Understanding such biases plays a very crucial role in managing portfolios and people’s wealth such as to adequately adjust or adapt when constructing or rebalancing portfolios over time. Relatively speaking, it is easier to accept and adapt biases within a portfolio for a high-net worth individual with a relatively low standard of living risk, particularly if biases are more on the emotion-type of the spectrum. Otherwise, more stringent consideration and adjustments are to be made, as ultimately ignoring such biases could easily impair the wealth accumulated for an individual over the medium-to-long term – realising the devastating consequences only too little too late. “The investor’s chief problem – and even his worst enemy – is likely to be himself.” – Benjamin Graham

 

Colin Vella, CFA is Head of Wealth Management at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]