BEHAVIOURAL FINANCE – WHAT’S YOUR PROBLEM?

Disagreeing with a Nobel Memorial Prize Winner

Back in 1970, Eugene Fama PhD, first published his Efficient Markets Theory that suggested all securities prices are explained in the context of what information sets are available.  However, he goes on to say…” when a model yields a predicted return significantly different from the actual return, one can never be certain if there exists an imperfection in the model or if the market is inefficient”.

Well, isn’t that all the time? Umm, Yeah! So what’s he missing? How about this…

Investors are irrational, therefore markets are irrational!

As a Portfolio Manager and private client advisor, it is in my humble opinion that markets are not efficient because investors are irrational. It is not the pure flow of available information but it is investor emotions, biases and misperceptions of the available information that drive markets. That’s not an insult or an indictment of our clients – it’s just part of the human condition.

So for the last 15 years I have been studying Behavioral Finance to understand why people want to invest the way they do. The depth of research and publication on Behavioral Finance has been around for a long time and is growing (from Kahneman to Taversky to Statman), but its acceptance and use in private client practice has generally been slow.

Remember “Irrational Exuberance”?

In the 1990s, it was then Fed Chairman Alan Greenspan that coined the term “irrational exuberance” bringing to the forefront that investor biases move markets.  He was describing a burgeoning overconfidence of investors (which is the number one cognitive bias by the way) in the U.S. financial markets.

Huh, imagine that – an entire population of investors exhibiting a cognitive bias – this one known as the “Overconfidence Bias”.

It’s nothing new

Irrational behaviour has been around for centuries and it should be freely acknowledged. And it is here that the skilled wealth advisor’s understanding and recognition of investor biases are required – to have that genuine conversation with the client about risk perception, financial needs and their meaning of money.

Understanding the investor biases can help improve their advisor-client relationship and help clients make better – rational – financial planning and investment decisions – to improve client’s financial outcomes.

So what is a “behavioral bias” anyway?

A bias can be described as “a preference or inclination – sometimes illogical, an imperfection in the perception of realityespecially one that inhibits impartial judgement”.

Illogical? Inhibits judgement? Really? Yes, I have seen it all (I could write a book! but I only have time for a blog).

That means there are no Spock-like investors.

Biases fall into two broad categories – both yielding irrational judgement.

  1. Cognitive Biases:
    • Defined as basic statistical, information processing or memory errors.
    • They stem from faulty conscious reasoning, but better information and advice can correct it.
      • Of course, I believe that everyone can benefit from better information I provide and my professional guidance – but maybe that’s just me exhibiting my own “Overconfidence Bias”.
  2. Emotional Biases:
    • Defined as illogical or distorted reasoning that arise spontaneously rather than from conscious effort.
    • They are physical expressions, often involuntary, arising from feelings, perceptions or beliefs about elements, objects or situations – in reality or imagined.
    • They stem from unconscious impulse or intuition and are therefore difficult to correct.
      • Emotional biases are tough to deal with – poor decisions are constantly made (not by my clients, of course) in plain view of better and correct information, and professional guidance – often finally resulting in the “unsolicited trade” or sometimes even having to let a client go.

Let’s have fun with Cognitive Failures!

Over the next few weeks I will have some fun with some of the most common cognitive and emotional biases and give you some investor examples. There are actually 14 cognitive biases and 6 emotional biases.  See if you can identify yourself in any of the upcoming examples.

We all have them. Which one are you?

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