How to avoid behavioural biases that impact you and your advisor
Both investors and their advisors make common investment mistakes that negatively impact investing outcomes. You or your advisor may be subject to behavioural biases that you should aim to identify and negate.
Kent Baker, Greg Filbeck, and Victor Ricciardi wrote an article in the European Financial Review discussing how behavioural biases affect finance professionals. They considered financial planners, portfolio managers, and institutional investors.
These are some of the investment mistakes people make as a result of these psychological biases.
Heuristics involves problem solving using mental shortcuts or simplistic approaches like rules of thumb to make quick judgements.
Advisors can sometimes be posed questions that they want to answer quickly for a client. Quick may not always be accurate, and investors should engage in thoughtful discussion with their advisors by asking “why” questions, or by encouraging their advisor to put some thought to a question or issue before commenting.
One of the best approaches may be to provide an advisor with an agenda prior to a meeting, to ensure they can reflect on their answers before giving them.
Related article: Questions to ask your financial advisor
Investors and advisors also engage in common asset allocation heuristics like investing aggressively for a young, single male or conservatively for an older married couple. Risk tolerance should be somewhat scientific, and by appropriately assessing personal risk tolerance, an older married couple may well end up investing more aggressively than their young male counterpart.
Familiarity bias, risk, and return
Home-country bias is a common tendency for investors around the world, who tend to focus their investing in their home country to the detriment of international diversification. Domestic stocks are often seen as less risky and perceived as earning a higher rate of return than international stocks (even if that’s not the case).
In Canada, this is a common misconception with bank stocks. While there are worse investments to overweight than our banks, in 2008, Royal Bank shares fell 29% in value. Sure, that was better than the 35% decline for the Toronto Stock Exchange that year, but the point is Canadian banks are not immune from losses or volatility.
Capital can move easily around the world in a matter of seconds with the push of a button, and it is this efficiency that means that our beloved Canadian banks are not a magic bullet. There is nothing to stop an investor in Singapore or London or New York from investing in Canadian banks if they offer a better return than other stocks in other countries.
At 3 per cent of global stock market capitalization, staying home means you are missing out on 97 per cent of what the world has to offer if you only buy Canadian.
Related article: Model Investment Portfolios
We can all suffer from overconfidence at times, and it can often take getting burned to make you modest. Prediction overconfidence can lead to unwarranted belief in your investing prowess. The increase in DIY investors in recent years has me on the lookout for overconfident investors who either got lucky or who overlook that good absolute performance does not mean their relative performance is good compared to a benchmark.
Overconfidence can also lead investors or advisors to manage more concentrated portfolios with fewer holdings or choose predictive ability over a consistent and identifiable investing framework.
Whether you have an advisor, or manage your own investments, remember that predictions are better suited for fortune tellers at the carnival than for your portfolio. You should have investing rules you follow rather than investing based on intuition.
Loss aversion and the disposition effect
Research has shown that investors often look at gains and losses differently in their portfolio. Investors may feel twice as much pain when they experience a 10 per cent loss, for example, than the satisfaction they feel from a 10 per cent gain.
This loss aversion may cause investors or their advisors to hold investments too long to recoup a loss.
In my opinion, an investor should consider how much they have invested in a particular investment at any given time. If they had that same value in cash, would they buy the investment? If not, consider selling. Even if it is at a loss, if there is a better place to make back that money, make it there instead of trying to make it back on a losing investment out of spite.
Related article: What is your sell discipline?
We can all be subject to biases at times and need to do our best to have an open mind. Young, new investors, as well as old, established ones are all at risk of behavioural biases (whether they are advisors or DIY investors).
Avoiding rules of thumb, investing globally, being modest, and selling if you wouldn’t otherwise buy can all help you be a better investor.
The worst bias is “advisors” are salespeople, with the exception of a tiny handful of fiduciaries. Your banks, broker, etc advice is predicated on selling you a product they happen to sell.
“You either pay for the product or you are the product,” holds very true when some guy/gal is flogging a turn key solution that they just happen to sell.
MLM’s like Primerica, IRP solutions, make this industry is about as sleazy as it gets.
I wonder if you can explain what you mean by avoiding “being modest”, as you indicate in your conclusion (but I did not see that phrase in the body of the article). Thank you.
The “being modest” reference coincides with the section about overconfidence. Advisors and investors are both at risk of being overconfident about their conviction to a specific stock, ability to predict market movements, or overstating their risk tolerance (particularly when stock prices are rising).
I think this is a valuable article and especially as it relates to the heuristics issue. I had a very frustrating experience with a financial advisor that constantly referenced “rules of thumb” and\or basic money management concepts.
The one that stands out is the view that, when you renew your mortgage, that “you should always take the one year rate”. The science is that taking the one year rate over a 25 year period does result in the fastest payout of the principal. However, I was 50 years old with a lot less than 25 years to go; so the concept doesn’t necessarily apply. The other example is needing 70% of current income for retirement; I needed a lot less for a variety of reasons.
I have lots of other examples but the key is to challenge the advisor on your specific circumstances.