In February, we held a masterclass for professional contacts on the topic of risk. One of the areas we looked at during the CPD session was attitude to risk when investing; in particular, the different effects our existing biases can have on the way we approach financial planning decisions.
Behavioural finance is a rapidly growing area of interest within financial services. The simple fact is that investors do not always operate in a rational or logical manner and are very easily swayed by biases. Depending on the significance of the decision, biases can, and do, have a direct impact on the performance of an investor’s portfolio.
Generally speaking, there are two types of biases that affect our financial decision making process. These are:
- Cognitive biases – Biases based on errors of perception, memory, judgment or reasoning.
- Emotional biases – The tendency to believe things that give us a good feeling and disbelieve things that make us feel uncomfortable.
Here we look at some of the most common biases people hold and how these manifest themselves in financial decision making.
This is the tendency to interpret new evidence as confirmation of one’s existing beliefs or theories. Think about the last car you bought. After you initially made the decision which make and model you were interested in, did you suddenly start to notice that car every time you drove past it? This is confirmation bias in action. If we already have a certain view about a particular type of investment, any information we are presented with will work to confirm our decision in this regard.
Framing bias refers to how people react to a particular choice depending on how it is presented. Framing bias is exploited frequently as a marketing tool; with prices presented in a certain way to make us feel we are getting a good deal, or else encouraging us to spend more than we originally intended. The FCA conducted an interesting piece of research on framing in relation to retirement planning options. One finding from the paper was that potential losses appear more important than the potential gains to the retiree; in this particular scenario impacting on their choice of whether to take an annuity or access flexibly via drawdown. This is a finding that has been mirrored by other research into framing bias in investor behaviour.
Loss aversion is linked very closely with framing bias and centres around our tendency to strongly prefer avoiding losses than acquiring gains. Some studies have suggested that losses are twice as powerful, psychologically, as gains. This is clearly an important bias in relation to investment behaviour as investing in stocks and shares always carries a risk of loss. Although the gains can be significant, some investors with a particularly strong bias for loss aversion will automatically lean towards a cautious portfolio. Establishing attitude to risk is one of the first steps we take when meeting with a potential client so that the portfolio suggestions we make are tailored correctly.
Overconfidence is a person’s tendency to overestimate their skills and abilities or predictions for success.
In investing, overconfidence can lead to rash decision making – such as selling stocks at the incorrect time, or favouring one particular asset type over another resulting in a poorly balanced portfolio.
Investing is more than just analysing numbers and making decisions to buy and sell. A large part of investing involves individual behaviour, preferences and emotions.
As financial advisers, it is our role to make recommendations for clients based on their personal circumstances and what they are aiming to achieve via their financial planning. Ultimately however, any investment decision must be made by the client, thus leaving the opportunity for investment biases to rear their head in place of rationality or good judgment.
Having an awareness of one’s own biases can help to reduce the extent of the impact expressed. However, a bias is not always something we are aware about; it’s often an inherent inclination or prejudice existing in our subconscious.
As an evolving area, the advisers at Gresham will be keeping an eye on the research surrounding behavioural finance and how we can help steer clients in the right direction when making investment decisions.