We are all unique individuals that behave differently. Our own individual experiences shape the way we behave and think. This is especially true when it comes to money. An entire field called Behavioral Finance deals with how we behave when it comes to money or investing. One of the more popular and interesting books on the topic is “The Psychology of Money” by Morgan Housel. Morgan is a leading expert in his field, an accomplished writer, and a quote-generating machine. In his book, he shares stories of how we interact with money and investing. One of the best quotes is, “Your personal experience makes up 0.00000001% of what’s happened in the world but maybe 80% of how you think the world works.”
Modern Portfolio Theory and the efficient market hypothesis are still considered the gold standard for examining and understanding financial markets. Paraphrasing one of the underlying assumptions used in the latter theory; “Investors make rational decisions that are objective, informed, and act only on available information.” We think everyone can agree that people do not act rationally 100% of the time. Behavioural Finance is a field that has become more popular over the last few decades as they examine why and how investors do not make rational decisions. Behavioral Finance enthusiasts would argue that investors, especially amateur investors, make investment decisions based on their own experiences rather than finance numbers and data.
Most investors have certain biases they utilize either consciously or unconsciously. Having a bias while investing is not necessarily a bad thing but something that we should be cognizant of when making decisions. We thought we would take a little dive into the world of Behavioural Finance and explore some of the common behaviourial biases we see from investors.
People are generally more comfortable investing in what they know and have seen before. Investing in your home country or region feels comfortable. Canadians are notorious for overweighting Canadian stocks. Canada makes up only 3-4% of the world’s stock market wealth, but we often see portfolios consisting of 40 – 60% of their equity position in the Canadian market. People are more comfortable buying a Canadian bank or a Canadian oil company vs. a global bank or a global oil company as the local stocks as more comfortable. By limiting the stocks you invest in, to only local stocks, your range of options becomes pretty narrow. This bias may help as you know more about the local investment, but it may also limit the opportunity set of available investments.
People don’t like being wrong. It has been proven that individuals prefer to win more than lose; this is why so many investors do whatever they can to avoid taking a loss (and being wrong). A common strategy we come across in discussions, is to hold a stock until it gets back to even, and then sell it. This strategy will ensure they never crystallize a loss, and the investor will never have to admit they were wrong. This bias will cause investors to hold stocks too long and possibly miss other opportunities.
Generally, individuals enjoy being agreed with. Confirmation bias is looking for people or research to agree with you. For example, If you want to employ a certain investment strategy, you actively search out people or research that agrees with your thesis. In this process, you gain support or confirmation of your theory and actively ignore opposing or contradictory research. This leads to doing what you originally wanted and is not necessarily an objective approach to your original idea.
Anchoring is when your past experience shapes your future experience. You are anchored in the past and not open to future possibilities. For example, “I lost money on buying gold, I am never doing it again” or, “I have made money investing in Canadian Banks for years, so I am going to continue buying those banks.” No matter the current situation, the investor becomes anchored in the past which doesn’t allow them to interpret new information or the current market.
Following the crowd can be the easiest thing to do. Many investors will make investments based on what others are doing. There is comfort in knowing someone else is investing in something, especially if someone is perceived as a “good investor” or a “smart person.” The typical example is the “hot stock” tip. This is when an investor buys a stock based on someone else’s recommendation without doing their own research. If a whole cohort is doing the same thing, people want to jump on the bandwagon even more. The challenge is the investor is not making their own decision and just following the crowd.
There are many more biases that shape an investor’s thought processes. At the very least, we should become conscious of these biases. As we become more aware of these biases, we can become more rational and successful investors. Professional money managers work hard to understand their own biases and tendencies. Investing and how we deal with money, is more complicated than what we think we know. If you're in need of some support navigating your investment decisions, contact one of our Wealth Counsellors to learn about Kinsted’s approach.