Emotional Behavioural Biases

Date postedNov 16, 2022

Emotional Behavioural Biases: What are they and what can I do about them?

Imagine you and I have agreed to play a simple game together. The game begins with me giving you $10 for agreeing to participate. I will then present to you two choices:

  • Choice A: I flip a coin, and as a result of heads, you gain an additional $10.
  • Choice B: I give you $5, and the game ends.

Which option would you choose? Most people would likely take the beneficial outcome of $15, while those who like to gamble may go ahead with the coin flip.

However, an interesting phenomenon happens in our decision-making process if we slightly alter the game’s rules:

  • Let’s suppose instead that Choice A is now to flip the coin, and the result of heads loses you $10 - meaning you could forfeit the original $10 I gave you at the start.
  • Selecting Choice B loses you $5 immediately, and your game ends with you having only gained $5.

The probability outcomes of each scenario have not changed, yet we find that most people will tend to choose the coin flip when presented with the prospect of losing money. Why is that? It’s because we tend to feel more discomfort with the possibility of losing money than we do with losing the happiness we feel when we gain money. This emotional phenomenon is called Loss Aversion. As its name implies, investors also tend to feel more pain whenever their portfolio loses them money versus joy when their portfolio makes them money. 

The subject of behavioural finance is a relatively new field of finance that focuses on humans’ inability to act rationally or process information logically. We are not robotic computers or Spock from Star Trek. We have a lifetime of different backgrounds, experiences, and emotions, which all play a part in our decision-making process. As a result, we don’t often make the most rational decisions when it comes to an emotional subject like money.

Money itself does not cause individuals to have an emotional response; instead, it’s what we associate money with that can cause us to feel stronger emotions. For example, investment portfolios are a nest egg of accumulated wealth to provide a certain level of lifestyle during retirement, or it is money inside one’s bank account to provide food, shelter, clothing, and entertainment. And because we must work to earn our money, we also have an appreciation for the tradeoff between the price of something and our perceived value. 

Behavioural finance breaks these human inadequacies into two broad categories:

  1. Cognitive biases
  2. Emotional biases

Cognitive biases are associated with an individual’s inability or unwillingness to reason. The second category is emotional biases, which is what will be discussed in this piece. There are many different emotional biases investors can exhibit. However, I will only list a few that we tend to see in our industry.

Have you ever heard someone bragging about their investment decision which led to a fantastic return? What you don’t often hear about are the other trades that didn’t work out well for them. This overconfidence bias can lull investors into a false sense of confidence in an ability they may not possess. Many intelligent people mistake a few brilliant stock picks during a rising bull market as evidence of their astute stock-picking prowess… Don’t fall into this trap! We have experienced the most significant and prolonged “bull market rally” since 2008. Remember, a rising tide lifts all boats. It’s natural for us to talk about our winners; however, it’s more important to learn from our losers and keep our egos in check. 

We live in a consumer-driven economy in North America, so it is no wonder that the average Canadian carries approximately $21,000 in consumer debt (excluding mortgages). I believe that this lack of self-control is also evident in our investing preferences. It can be challenging to stay focused on our long-term portfolio goals and not panic when turbulent storms arise in the financial markets. We tend to be very short-term focused on what is happening today, this week, this month, or at quarter end. We get so caught up in the day-to-day happenings that we can sometimes lose sight of the big picture.

Sticking to the course of your investments is essential, not altering your portfolio or selling assets too early in favor of receiving short-term gains. Short-term gains are reasonable; however, long-term returns on continuous compounding have the strongest track record for financial success. Do not make the mistake of choosing short-term gratification at the expense of your long-term portfolio goals. 

Have you ever done spring cleaning and come across something given to you by a loved one years ago? You forgot that you even had this thing, yet you kept it all these years for some reason, and you can’t bear to part with it. If this has happened to you, you’re not alone. Many of us hold on to things for sentimental reasons. However, we must be mindful of the sentimental attachments we sometimes have for unhelpful assets we may be holding on to inside our investment portfolios. Investors sometimes fail to sell or realize capital gains inside their investment portfolios if they have a similar sentimental attachment to the asset. Investors should instead separate their appreciation for the asset and remain disciplined with their decision-making regarding the asset’s purpose inside the investment portfolio.

If you feel that you may have some of these emotional and behavioural biases, don’t worry. Everyone has them, even us investment professionals. Therefore, it is VERY important to learn about these topics so that investors and investment counsellors can work together to get the best results for your portfolio. Working with a Wealth Counsellor helps you to identify some of your less obvious behavioural biases. We can coach you and craft a customized portfolio that suits your needs and is tailored to your specific behavioural preferences. We’ll work to protect you from falling into some of these behavioural bias pitfalls and will help navigate you throughout your wealth journey. If you’re in need of some support navigating your investment decisions, contact one of our Wealth Counsellors to learn about Kinsted’s approach.  

- Daniel Roy