How Be­havioural Bi­ases Af­fect Fi­nance Pro­fes­sion­als

A bet­ter un­der­stand­ing of Psy­chol­ogy can as­sist Fi­nance pro­fes­sion­als in achiev­ing their clients’ long-term fi­nan­cial ob­jec­tives.

Rotman Management Magazine - - CONTENT - By H. Kent Baker, Greg Fil­beck and Vic­tor Ricciardi

A bet­ter un­der­stand­ing of hu­man psy­chol­ogy can as­sist fi­nance pro­fes­sion­als at all lev­els in achiev­ing their clients’ long-term fi­nan­cial ob­jec­tives.

THE LIT­ER­A­TURE HAS DOC­U­MENTED a wide va­ri­ety of be­havioural bi­ases in fi­nan­cial mar­kets: In­di­vid­u­als are over­con­fi­dent, they ex­hibit loss aver­sion, they demon­strate fa­mil­iar­ity bias, and they are driven by mood and sen­ti­ment, to name a few. When such bi­ases af­fect the de­ci­sion mak­ing of fi­nance pro­fes­sion­als, they can quickly be­come their own worst en­e­mies.

It is widely be­lieved that less-so­phis­ti­cated in­vestors make poorer choices than their pro­fes­sional coun­ter­parts. But the fact is, fi­nan­cial pro­fes­sion­als are hu­man, too. In this ar­ti­cle we will look at which par­tic­u­lar bi­ases are most likely to af­fect three cat­e­gories of fi­nance pro­fes­sion­als: Fi­nan­cial plan­ners and ad­vi­sors; fi­nan­cial an­a­lysts and port­fo­lio man­agers; and in­sti­tu­tional in­vestors. A bet­ter un­der­stand­ing of these bi­ases can help fi­nance pro­fes­sion­als achieve their clients’ long-term fi­nan­cial ob­jec­tives.

Key Bi­ases for Fi­nan­cial Plan­ners and Ad­vi­sors

Fi­nan­cial plan­ners and ad­vi­sors, along with their clients, re­veal a wide ar­ray of psy­cho­log­i­cal bi­ases that can re­sult in flawed judg­ments and de­ci­sions. But for this group, be­ing aware of the fol­low­ing bi­ases is par­tic­u­larly im­por­tant.

HEURIS­TICS. Fi­nan­cial plan­ners of­ten ex­clude spe­cific in­for­ma­tion or process in­for­ma­tion in­cor­rectly when ad­vis­ing clients. That’s be­cause they ap­ply heuris­tics or ‘men­tal short­cuts’ when pro­cess­ing large amounts of data or sta­tis­tics — which of­ten re­sults in er­rors.

For ex­am­ple, a fi­nan­cial plan­ner may use a heuris­tic that ‘mar­ried in­di­vid­u­als are less tol­er­ant of risk than sin­gles’ and there­fore, rec­om­mend con­ser­va­tive in­vest­ment prod­ucts to mar­ried clients. Clearly, not ev­ery mar­ried in­vestor should be

placed into this risk stereo­type. The re­search shows that many such ‘heuris­tic judg­ments’ re­sult in er­rors, poor ad­vice, and lower in­vest­ment per­for­mance.

AN­CHOR­ING. An­chor­ing is the ten­dency for an in­di­vid­ual to hold a be­lief and then ap­ply it as a ‘ref­er­ence point’ when mak­ing fu­ture judg­ments. Plan­ners and ad­vi­sors of­ten base their de­ci­sions on the first piece of in­for­ma­tion they re­ceive — such as a stock’s ini­tial pur­chase price — and they of­ten have dif­fi­culty mod­i­fy­ing their as­sess­ment of new in­for­ma­tion. For ex­am­ple, when they ‘an­chor’ on a los­ing in­vest­ment as a bad ex­pe­ri­ence, they can be­come ex­ces­sively risk- and loss-averse, re­sult­ing in un­der­weight­ing other stocks in a port­fo­lio.

FA­MIL­IAR­ITY BIAS. Plan­ners, ad­vi­sors and their clients of­ten show a pref­er­ence to own ‘fa­mil­iar’ as­sets. For in­stance, they show an in­cli­na­tion to in­vest in lo­cal se­cu­ri­ties with which they are most fa­mil­iar, thus over-weight­ing port­fo­lios in do­mes­tic as­sets. They also tend to per­ceive fa­mil­iar as­sets as less risky and earn­ing a higher rate of re­turn, which can re­sult in un­der-di­ver­si­fi­ca­tion in a port­fo­lio and re­sult­ing lower per­for­mance.

TRUST AND CON­TROL. An im­por­tant char­ac­ter­is­tic of the client-ad­vi­sor re­la­tion­ship is de­vel­op­ing a bal­ance be­tween trust and con­trol. Clients of­ten place too much trust in plan­ners and ad­vi­sors or overly al­lo­cate con­trol about de­ci­sions to them. Con­versely, when clients lack trust and are con­trol­ling, they are un­likely to lis­ten to fi­nan­cial ad­vice. Fi­nan­cial plan­ners must work to es­tab­lish a bal­anced re­la­tion­ship of trust and con­trol with ev­ery client.

WORRY. Both fi­nan­cial plan­ners and their clients com­monly suf­fer from worry, but it doesn’t ap­ply to all prod­ucts equally. One of the au­thors [ Vic­tor Ricciardi] found that a large ma­jor­ity of in­vestors as­so­ciate the term ‘worry’ with stocks rather than bonds. A higher de­gree of worry for stocks in­creases per­ceived risk, low­ers the de­gree of risk tol­er­ance among in­vestors, and de­creases the like­li­hood of own­ing the in­vest­ment.

Bi­ases for Fi­nan­cial An­a­lysts and Port­fo­lio Man­agers

Fi­nan­cial an­a­lysts and port­fo­lio man­agers are par­tic­u­larly sus­cep­ti­ble to the be­havioural bi­ases de­scribed be­low. Left unchecked, these bi­ases can se­verely dam­age their rep­u­ta­tion.

OVER­CON­FI­DENCE. This bias man­i­fests it­self as an un­war­ranted faith in one’s own in­tu­itive rea­son­ing, judg­ment and cog­ni­tive abil­i­ties and in­cludes both pre­dic­tion over­con­fi­dence and cer­tainty over­con­fi­dence. Pre­dic­tion over­con­fi­dence oc­curs when pro­fes­sion­als as­sign too nar­row a con­fi­dence in­ter­val around their in­vest­ment fore­casts; while cer­tainty over­con­fi­dence oc­curs when pro­fes­sion­als as­sign too high a prob­a­bil­ity to their pre­dic­tion and have too much con­fi­dence in the ac­cu­racy of their judg­ments. These bi­ases have been shown to lead to overly-con­cen­trated port­fo­lios, as these in­di­vid­u­als may as­sume that their per­ceived su­pe­rior skills war­rant in­clud­ing fewer as­sets for con­sid­er­a­tion.

HERD­ING BE­HAV­IOUR. Herd­ing refers to dis­re­gard­ing one’s own opin­ion or anal­y­sis in or­der to fol­low the crowd — which can lead to fi­nan­cial bub­bles and crashes. As prices in­crease from in­vestors cap­i­tal­iz­ing on mo­men­tum, these in­di­vidu­uals may ob­serve their peers in­vest­ing in these as­sets and thus be in­cen­tivised to

fol­low suit. If they fail to fol­low the herd, they risk trail­ing be­hind their peers; how­ever, if they fol­low the herd, they may get caught on the wrong side of an ar­ti­fi­cially-at­trac­tive op­por­tu­nity.

LOSS AVER­SION AND THE DIS­PO­SI­TION EF­FECT Ac­cord­ing to Daniel Kah­ne­man and the late Amos Tver­sky, in­vestors treat the gains and losses in their port­fo­lio very dif­fer­ently. Loss aver­sion, which comes from Prospect The­ory, sug­gests that man­agers sig­nif­i­cantly over­weight losses com­pared to an equiv­a­lent gain. This be­hav­iour re­sults in the dis­po­si­tion ef­fect, whereby pro­fes­sion­als rec­om­mend sell­ing se­cu­ri­ties to lock in gains too quickly, and rec­om­mend re­tain­ing se­cu­ri­ties too long in or­der to re­coup losses. These fi­nance pro­fes­sion­als may ex­hibit both be­hav­iours in mon­i­tor­ing a sin­gle se­cu­rity in a port­fo­lio.

GEN­DER DIF­FER­ENCES. Al­though women rep­re­sent only nine per cent of port­fo­lio fund man­agers, mu­tual funds man­aged by fe­male port­fo­lio man­agers per­form in line with those man­aged by men. In­ter­est­ingly, funds with mixed gen­der teams of both male and fe­male port­fo­lio man­agers ex­hibit su­pe­rior per­for­mance. Al­though both gen­ders can dis­play over­con­fi­dence in their abil­i­ties, re­search shows that men are con­sis­tently more over­con­fi­dent than women in their pre­dic­tions, par­tic­u­larly when re­lated to fi­nance.

CON­FIR­MA­TION BIAS. This bias causes an­a­lysts to over­weight in for­ma­tion that con­firms their prior be­liefs and to un­der­weight in­for­ma­tion that runs counter to their prior be­liefs. The re­sult: Rec­om­men­da­tions may be based on pre­vi­ous choices.

OVER-OP­TI­MISM. Em­pir­i­cal re­search finds that in­di­vid­u­als can be ex­ces­sively op­ti­mistic in both their earn­ings fore­casts and stock rec­om­men­da­tions. One study found that man­age­ment ac­tu­ally prefers op­ti­mistic fore­casts, be­cause they in­crease mar­ket val­u­a­tions and there­fore man­age­ment com­pen­sa­tion. In sup­port of this be­lief, re­searchers found that sell rec­om­men­da­tions com­prise only six per cent of their sam­ple of rec­om­men­da­tions, whereas buy- and-hold rec­om­men­da­tions com­prise the re­main­ing 94 per cent.

Bi­ases for In­sti­tu­tional In­vestors

In­sti­tu­tional in­vestors are pro­fes­sional in­vestors work­ing for in­sur­ance com­pa­nies, banks, pen­sion funds, en­dow­ment funds, mu­tual funds and hedge funds. Ev­i­dence in­di­cates that these so­phis­ti­cated in­vestors are less sub­ject to some of the more com­mon be­havioural bi­ases dis­cussed thus far; how­ever, they can still be af­fected by the fol­low­ing bi­ases.

HERD­ING BE­HAV­IOUR. Like an­a­lysts and port­fo­lio man­agers, in­sti­tu­tional in­vestors can dis­play a propen­sity to herd or fol­low each other’s trades. If herd­ing is ir­ra­tional or driven by be­havioural mo­ti­va­tions such as fads, greed, fear or rep­u­ta­tional con­cerns, it can de-sta­bi­lize as­set prices and move them away from their fun­da­men­tal val­ues. Con­versely, herd­ing be­hav­iour can be ra­tio­nal and in­for­ma­tion-based. If so, it can lead to more ef­fi­cient mar­kets and/or to higher risk-ad­justed re­turns to in­vestors.

Two rea­sons largely ex­plain why in­sti­tu­tional in­vestors en­gage in herd­ing be­hav­iour. First, they in­fer in­for­ma­tion from each other’s trades. Sec­ond, they an­a­lyze sim­i­lar in­for­ma­tion and draw the same con­clu­sions about the fair value of spe­cific se­cu­ri­ties. Hence, herd­ing by these in­di­vid­u­als tends to be un­in­ten­tional and in­for­ma­tion-driven. In one study, re­searchers con­cluded that herd­ing by in­sti­tu­tional in­vestors, in gen­eral, ap­pears to be price sta­bi­liz­ing rather than price desta­bi­liz­ing.


Al­though Port­fo­lio The­ory in­di­cates that in­vestors should BIAS. hold di­ver­si­fied port­fo­lios, in­sti­tu­tional in­vestors do not al­ways

Men are con­sis­tently more over­con­fi­dent than women in their pre­dic­tions, par­tic­u­larly when they re­late to fi­nance.

do so. In­stead, they of­ten ex­hibit home bias, which is the ten­dency to in­vest mainly in do­mes­tic eq­ui­ties, de­spite the pur­ported ben­e­fits of di­ver­si­fy­ing into for­eign eq­ui­ties. Var­i­ous be­havioural at­tributes might ex­plain the ir­ra­tional­ity of over­weight­ing in do­mes­tic mar­kets, in­clud­ing over­con­fi­dence, op­ti­mism and fa­mil­iar­ity. Over­con­fi­dent in­vestors over­es­ti­mate the ac­cu­racy of their pri­vate in­for­ma­tion, judg­ment and in­tu­ition; those with op­ti­mism bias be­lieve that they are less at risk of ex­pe­ri­enc­ing a neg­a­tive event com­pared to oth­ers; and those with fa­mil­iar­ity bias trade in the se­cu­ri­ties with which they are fa­mil­iar. All three bi­ases can lead to un­der­es­ti­mat­ing the amount of risk in the in­vest­ment and thus not tak­ing the req­ui­site steps to re­duce risk, such as di­ver­si­fy­ing.

How­ever, un­der-di­ver­si­fi­ca­tion can also bea ra­tio­nal strat­egy driven by in­for­ma­tion ad­van­tage. If this is the case, un­der-di­ver­si­fi­ca­tions hould not lead to de­te­ri­o­rat­ing per­for­mance. One re­cent study found that un­der-di­ver­si­fied po­si­tions earn higher risk-ad­justed re­turns than glob­ally-di­ver­si­fied port­fo­lios; and another study found that in­sti­tu­tional in­vestors, es­pe­cially in the realm of mu­tual funds, ac­tu­ally out­per­form when hold­ing lo­cally-con­cen­trated port­fo­lios. Thus, un­der-di­ver­si­fi­ca­tion gen­er­ally tends to be a ra­tio­nal, not a bi­ased choice for in­sti­tu­tional in­vestors.

MO­MEN­TUM TRAD­ING. This refers to an in­vest­ment strat­egy that tries to ben­e­fit from the con­tin­u­ance of ex­ist­ing mar­ket trends. Al­though all types of in­sti­tu­tions en­gage in mo­men­tum trad­ing, ev­i­dence shows that they do not do so be­cause of greed, fear, over­con­fi­dence, or rep­re­sen­ta­tive­ness bias, but for fun­da­men­tal rea­sons. A 2017 study con­cluded that us­ing a ‘mo­men­tum strat­egy’ is ac­tu­ally value-gen­er­at­ing, be­cause in­sti­tu­tional in­vestors ap­pear to buy past win­ners. More­over, they are less sub­ject in gen­eral to be­havioural bi­ases and gen­er­ally con­trib­ute to mak­ing mar­kets more ef­fi­cient.

In clos­ing

Be­havioural bi­ases can dra­mat­i­cally af­fect the be­hav­iour of all types of fi­nance pro­fes­sion­als. But the ev­i­dence re­veals that as in­vestor so­phis­ti­ca­tion in­creases from in­di­vid­ual in­vestor through to in­sti­tu­tional in­vestor, the bi­ases dis­played do in fact de­crease — and some even dis­ap­pear. Re­gard­less of their cur­rent role, Fi­nance pro­fes­sion­als across the board can ben­e­fit from fa­mil­iar­iz­ing them­selves with all of the po­ten­tial bi­ases de­scribed herein.

H. Kent Baker is the Univer­sity Pro­fes­sor of Fi­nance at Amer­i­can Univer­sity’s Ko­god School of Busi­ness in Wash­ing­ton, DC. The Jour­nal of Fi­nance Lit­er­a­ture has rec­og­nized him as among the top one per cent of pro­lific au­thors in fi­nance over the past 50 years. Greg Fil­beck holds the Samuel P. Black III Pro­fes­sor of Fi­nance and Risk Man­age­ment at Penn State Erie and serves as the In­terim Di­rec­tor for its Black School of Busi­ness. Vic­tor Ricciardi is an As­sis­tant Pro­fes­sor of Fi­nan­cial Man­age­ment at Goucher Col­lege in Bal­ti­more. This ar­ti­cle draws on themes from their book, Fi­nan­cial Be­hav­iour – Play­ers, Ser­vices, Prod­ucts, and Mar­kets (Ox­ford Univer­sity Press, 2017). It was first pub­lished in The Euro­pean Fi­nan­cial Re­view (eu­ro­pean­fi­nan­cial­re­view. com) and is reprinted with per­mis­sion.

If herd­ing is ir­ra­tional or driven by be­havioural mo­ti­va­tions such as greed, it can de-sta­bi­lize as­set prices.

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