Behavioural Finance - Breed Elliott

March2016August2018Behavioural FinanceIn this newsletter, we aim to provide a practical introduction to behavioural finance and highlightthe potential lessons for successful investing.The behavioural biases we discuss are ingrained aspects of our human decision-makingprocesses. Many of them have served us well as ways of coping with day-to-day choices.But, they may be unhelpful for achieving success in long-term activities such as investing. Weare unlikely to find a ‘cure’ for the biases, but if we are aware of them and their potential impact,we can avoid the major pitfalls.This newsletter focuses on learning about our own biases, so that we can make smarterinvestment decisions.

What is behavioural finance?OverconfidenceBehavioural finance studies the psychology offinancial decision-making and how emotionsaffect investment decisions. In our industry,we commonly talk about the role greed andfear play in driving stock markets.Behavioural finance extends this analysis tothe role of biases in decision making, such asthe use of simple rules of thumb for makingcomplex investment decisions. In otherwords, behavioural finance takes the insightsof psychological research and applies them tofinancial decision-making.Psychology has found that humans tend tohave unwarranted confidence in their owndecision making. In essence, this meanshaving an inflated view of our own abilities.Over the past fifty years established financetheory has assumed that investors have littledifficulty making financial decisions and arewell-informed, careful and consistent. Thetraditional theory holds that investors are notconfused by how information is presented tothem and not swayed by their emotions.But clearly reality does not match theseassumptions. Behavioural finance has beengrowing over the last twenty years specificallybecause of the observation that investorsrarely behave according to the assumptionsmade in traditional finance theory.Established financial theory focuses on thetrade-off between risk and return. However,behavioural finance suggests investors areoverconfident with respect to making gainsand oversensitive to losses.Research in psychology has documented arange of decision-making behaviours calledbiases. These biases can affect all types ofdecision-making, but have particularimplications in relation to money andinvesting.A variety of documented biases arise inparticular circumstances, some of whichcontradict others. The following sectionsdiscuss the key biases and their impact oninvestors.In practical terms, we tend to view the worldin positive terms. While this behaviour canbe valuable – it can help us to recover fromlife’s disappointments more quickly – it canalso cause an ongoing source of bias inmoney-related decisions.For example: If we are overconfident, we mayoverestimate our ability to identify winninginvestments. Traditional financial theorysuggests holding diversified portfolios sothat risk is not concentrated in anyparticular area. Overconfidence mayweigh against this advice, and we maybecome convinced of the good prospectsof a given investment, causing us tobelieve that diversification is, therefore,unnecessary.

As an overconfident investor, we mightbelieve that we can exercise more controlover our investments than we really do. Inone study, affluent investors reported thattheir own stock-picking skills were criticalto portfolio performance. In reality, theywere unduly optimistic about theperformance of the shares they chose andunderestimated the effect of the overallmarket on their portfolio’s performance. If we have too much confidence in ourtrading skills, we may trade too much, witha negative effect on returns. A number ofstudies have shown that more activetraders earn lower returns than those whosit and hold. Overconfidence may be fuelled byanother characteristic known as‘self-attribution bias.’ In essence, thismeans that, faced with a positive outcomefollowing a decision, we will view thatoutcome as a reflection of our ability andskill. However, when faced with a negativeoutcome, we attribute this to bad luck ormisfortune.Loss aversionAs already mentioned, established financialtheory focuses on the trade-off between riskand return. Risk from this perspective meansvariability of outcomes and riskierinvestments should, broadly speaking, offerhigher rates of return as compensation forhigher risk. The theory assumes thatinvestors seek the highest return for the levelof risk they are willing and able to bear.The idea of loss aversion includes the finding that people try to avoid locking in a loss.Consider an investment bought for 1,000,which rises quickly to 1,500. The investorwould be tempted to sell it in order to lock-inthe profit.In contrast, if the investment dropped to 500, the investor would tend to hold it toavoid locking in the loss. The idea of a lossis so painful that we tend to delayrecognising it.More generally, investors with losingpositions show a strong desire to get back tobreak even. This means the investor showshighly risk-averse behaviour when facing aprofit (selling and locking in the sure gain)and more risk tolerant or risk seekingbehaviour when facing a loss (continuing tohold the investment and hoping its pricerises again).A related issue is a tendency for emotions tosway us from an agreed course of action –‘having second thoughts.’ The human desireto avoid regret drives these behaviours.Inertia can act as a barrier to effectivefinancial planning, stopping us frominvesting and/or making necessary changesto our portfolios.

How we think about portfoliosManaging diversificationFinance theory recommends that we treat allof our investments as a single pool, orportfolio, and consider how the risks of eachinvestment offset the risks of others within theportfolio.Whilst we understand the critical importanceof portfolio diversification, behaviouralfinance research suggests we sometimesstruggle to apply the concept in practice.We are supposed to think comprehensivelyabout our wealth. Rather than focusing onindividual securities or simply our financialassets, traditional financial theory believesthat we consider our wealthcomprehensively, including our house,pensions, government benefits and ourability to produce income.However, human beings tend to focusoverwhelmingly on the behaviour ofindividual investments or securities. As aresult, in reviewing portfolios we have anatural tendency to fret over the poorperformance of a specific asset class or fund.These ‘narrow’ frames tend to increase oursensitivity to loss.By contrast, by evaluating investments andperformance at the aggregate level, with a‘wide’ frame, we may exhibit a greatertendency to accept short-term losses andtheir effects.Evidence suggests that investors use naïverules of thumb for portfolio construction inthe absence of better information.One such rule has been dubbed the ‘1/n’approach, where investors allocate equallyto the range of available asset classes orfunds (‘n’ stands for the number of optionsavailable).This approach ignores the specificrisk-return characteristics of the investmentsand the relationships between them, asdiscussed in last month’s newsletter.Investors have also been documented toprefer investing in familiar assets as theyassociate familiarity with low risk, e.g.investing just in the UK. The danger can beone of inadequate diversification.

Using (or misusing) informationResearchers have documented a number of biases in the way in which we filter anduse information when making decisions. In some cases, we use basic mental shortcutsto simplify decision-making in complex situations. Sometimes these shortcuts arehelpful, in other cases they can mislead.Decisions can be ‘anchored’ by the way information is presented. For example, valuessuch as market index levels can act as anchors. Round numbers such as 6,500 pointson the FTSE 100 Index, seem to attract disproportionate interest, despite them beingnumbers like any other.We are also more likely to be fearful of a stock market crash when one has occurred inthe recent past or assume that the past performance of a fund is an indication of itsfuture performance or cling to an initial judgement in spite of new contradictoryinformation.Managing the biasesIt would be the height of overconfidence if we, as financial planners, claimed that wewere immune to these behavioural biases.We cannot cure the biases, but we can attempt to mitigate their effects through ouradvice process and the regular monitoring and reviewing of your portfolio.Seeking to understand our clients’ future aims and aspirations, discussing investmentrisk in detail, earmarking funds for specific objectives, agreeing a benchmark assetallocation for each specific portfolio, rebalancing portfolios into line with the benchmark,playing devil’s advocate rather than just agreeing with what our clients say, etc. are alltechniques we use to help our clients to make decisions in a more rational manner andimprove the chances of investment success.

Value at thestart of 2018CurrentsituationCommentsInterest Rates(BOE baserate)0.25%0.50% at31.07.18The official bank rate is 0.5%House Prices(Nationwide)House pricesincreased by2.6% in 2017House pricesup by 0.5%at 31.07.187142.837700.85at the close on30.07.18MarketUK SharePrices(FTSE 100)UK annual house price growth has softened to 2%The FTSE 100 climbs into ‘positive territory’ followingthe latest batch of company releasesIf you have received this email in error, please contact us on the email below with your correct details orremoval request neilmiller@breedelliott.co.ukThe information contained in and transmitted with this email is confidential and/or privileged and intended only for theperson to whom it is addressed. Any unauthorised use, retransmission, dissemination or action undertaken based onthis information by persons, or entities other than the intended recipient, is strictly prohibited.The information contained in this newsletter is for information purposes only and does not constitute advice, if youdon't understand any of its contents we recommend you seek Independent Financial Advice .

Behavioural Finance In this newsletter, we aim to provide a practical introduction to behavioural finance and highlight the potential lessons for successful investing. The behavioural biases we discuss are ingrained aspects of our human decision-making processes. Many of them have