Introducing Behavioral Finance Theory for Individual Investors

Article originally posted on SureDividend.com

Individual stock pickers and passive investors can both benefit from becoming more aware of emotional biases.

These biases can cost you returns and lead to mistakes when managing risk. Below you will find the most common biases we see, how to keep them in check, and get an investment manager’s take on managing emotions.

Leave the emotions at the door! Educate yourself so you are aware and don’t make those mistakes.

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Discover if You’re an Emotionally Driven Investor

Do you know what your investor personality is? Are you a Preserver, Follower, Independent, or Accumulator? Surprisingly, this can be a tough nut to crack for most investors.

At Artesys, this understanding of behavioral finance is a big part of what we do because it allows us to make better informed decisions about each of our clients’ portfolios.

For those that are investing for themselves, being aware of your investor personality is essential for financial success. The purpose of understanding your investor type is to take advantage of your strengths and limit any obstacles that could hinder you from reaching your financial goals.

We could write an entire article about this topic, but for now, we will focus on the two most emotional investors: Preservers and Accumulators.

1. Preservers

Snapshot:

Basic Type: Passive
Risk Tolerance Level: Low
Primary Bias: Emotional
Common attributes:

At Artesys, we consider Preservers as defensive investors. As the name indicates, Preservers are passive investors that value taking care of their family members and future generations. Because of this, these investors are worriers and frequently more emotional than cognitive. They are focused on risk more than gain, as well as keeping more than investing.

Commonly, Preservers have gained their wealth through inheritance or conservatively by working at large companies. In terms of large expenses, they lean towards further education and home buying. They have trouble with decision making, due to putting too much weight into the potential for negative outcomes. Preservers are the type of people that go to casinos just to watch their friends gamble, but not participate themselves.

Advice:

If you find yourself in the Preserver category, try to focus on the big picture view, rather than on the maybe less important details. Oftentimes, the key to longer-term success is to stay the course through short-term volatility. And while it’s easier said than done, try your best to leave your emotions at the door.

2. Accumulators

Snapshot:

Basic Type: Active
Risk Tolerance Level: High
Primary Bias: Emotional
Common attributes:

At Artesys, we consider Accumulators as offensive investors. The attribute that Preservers and Accumulators have most in common is that they both share the primary bias of emotion. However, Accumulators are the most aggressive and active type of investor. They are comfortable risking their own capital in order to achieve their wealth objectives because they believe in themselves.

Oftentimes, these investors are entrepreneurial in nature and the first to create generational wealth. They want to be involved in investment decision making. In fact, they are quick decision makers and sometimes trade too much. Accumulators are the type of people that thoroughly enjoy gambling at casinos because they’re overconfident and love the thrill of making a good investment choice.

Advice:

If you relate to the Accumulators investor type, then it’s important to remember the impact financial decisions may have on family members, lifestyle, and legacy. Optimism is a really good thing to have, but make sure to combine that with controlled spending. Patience is a virtue. Keep in mind that long-term investment strategies have the potential for even greater results.

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Does either of these resonate with you?

Regardless of investor profile, most individuals exhibit emotional biases when making investment decisions.

Where Do These Emotional Biases Come From?

Biases result when decision making is made with the emotional side of the brain vs the systematic side. Commonly, investors exhibit these biases even when they are aware of them. Our suggestion, process information slowly and use critical thinking when making investment decisions. Here are some of the most common behavioral biases

1. Loss Aversion

This bias has to do with investors fearing loss more than they value gains. Numerous studies have shown that, on average, the potential for loss is twice as powerful a motivator as the potential for gain of equal amount. More specifically, “a loss-averse person might demand, at minimum, a $2 gain for every $1 placed at risk” (Dobbs, Wiley & Sons, 2015).

The result: Loss aversion can cause people to avoid selling unprofitable investments, despite little-to-no sign of things turning around, and to sell winning investments too quickly to dodge potential risk. This domino effect can lead to increased risk with lower returns– the exact opposite of what any investor would want. Investors with this bias should shift their focus on taking risk to increase gains, not to mitigate losses.

2. Overconfidence

When investors are overconfident, it means they have an unjustified optimism in their intuitive reasoning, decisions, and abilities. Simply put, investors with this bias are emotionally charged and think they are smarter and have more adequate knowledge than the reality. These investors may buy into a “get rich quick” scheme. For example, they may gain a nugget of information from a financial professional, an article, or a video, which then leads them to believe that they’re ready to take action, based on the perceived ‘key’ to financial success.

The result: Overconfident investors can sometimes be blinded by their own self-esteem, which causes them to miss crucial red flags about whether a stock should be bought, or a stock that was already purchased should be sold. Additionally, these investors can trade excessively or hold under-diversified portfolios. Much of these common mistakes are due to these overconfident investors underestimating their downside risks, leading to poor portfolio performance.

3. Self-control

Self-control bias is when investors sabotage their own long-term objectives in exchange for short-term satisfaction, due to a lack of self-control. Some real-life examples of this include when a person desires to save money to buy a home but goes on multiple expensive vacations; when a person desires to lose extra weight but cannot avoid the temptation of a triple chocolate sundae.

The result: Investors who have the self-control bias typically have trouble saving money. Retirement comes quick, and as a result of their spending habits and poor planning, these investors haven’t saved enough. Because of this, these investors accept inappropriate amounts of risk on their portfolio to make up for lost time. Self-control investors also frequently have asset-allocation imbalance problems, as well as lack basic financial principles.

4. Status quo

Investors with this bias prefer the current state of affairs over change. The current baseline or status quo is taken as a reference point, and any change from the baseline is perceived as a loss. The phrase ‘if it ain’t broke, don’t fix it’ rings true here. Both endowment and loss aversion biases are contributors to the status quo. For example, status quo bias often occurs for adults who have a hard time switching to a different bank account from the one they opened when they were young, even if the features will be better.

The result: Status quo investors take unnecessary risks or invest too cautiously. In order to avoid loss, these investors maintain the status quo of their current, low-performing investments, rather than reallocating to potentially a better opportunity, especially if there’s a transaction cost associated. They will also hold familiar securities that they have tied an emotional attachment to, compromising financial performance.

5. Endowment

Endowment bias is when someone values an asset more if they own it, or even feel like they own it. The prospect of selling or losing an asset has a stronger influence on our decision making than purchasing or gaining an asset. For example, if a person inherited an investment option, they are more likely to want to retain it, even if they are presented with a different option without penalty of switching.

The result: Similar to status quo and loss aversion, investors with endowment bias may hold onto securities that they already own to avoid transaction costs and because they’re familiar with them. In most cases, this leads to poor portfolio performance in the long-term.

6. Regret Aversion

The regret aversion bias occurs when investors desire to avoid the responsibility and feeling of regret that comes with choosing the wrong investments. These investors have trouble making decisions in the first place, but when they do and it turns out bad, they will dwell on their mistake. These investors may be tempted to follow what the crowd is doing, so they feel less regret if things go south.

The result: When it comes to their investments, regret averse people will retreat when aggressive behavior could be ideal, fearing the worst will happen. They are also less likely to sell a stock that has recently performed well, despite being advised to move on. Because they desire to alleviate responsibility for mistakes, they may not choose the most appropriate investment choices for their circumstances.

7. Affinity

Affinity bias is when investors tend to gravitate towards investments that they are more familiar with or will positively reflect their values. Furthermore, affinity biased investors focus mainly on expressive benefits of a product or service, rather than the utilitarian benefits, which are what the product or service actually does. For a real-life example, people who buy expensive wine for their dinner party versus the less expensive alternative that tastes relatively the same, may have affinity bias.

The result: These investors make the most mistakes by not adequately reviewing each of their investments. They may invest in companies that share their environmental, social, and governance (ESG) values, instead of looking at their investment performance. Or these investors will invest in securities that offer a level of sophistication or status. All of these behaviors can cause investors to suffer from poor portfolio performance.

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Keeping these biases in mind can help investors no matter the goal. At Artesys, our goal is to deliver a long-term, high-quality, globally diversified portfolio that generates competitive risk-adjusted returns over full market cycles… and of course, keeping these biases and investor profiles in mind.

Sources:

“Behavioral Finance Theory.” The Investment Advisor Body of Knowledge: Readings for the CIMA Certification, by Jim Dobbs, John Wiley & Sons, Inc., 2015.  