Personal Finance

Understanding behavioural economics can help you avoid harmful biases.
By Ashley Redmond | 06/11/14

Interest in behavioural finance has grown since the tumultuous financial crisis of 2008-09 that rocked North American and global markets. The crisis smashed many records, but not the good kind. Notably, on Sept. 29, 2008, the Dow Jones Industrial Average declined 774 points compared to the previous day's close, which is the largest single-day point drop in history.

About the Author
Ashley Redmond is a Vancouver-based freelance writer.

A crisis like that, or like the disaster that happened in Japan in 2011, puts investors on high alert, and many don't know whether to buy, sell or hold their investments. In times of turmoil it's important for an investor to know themselves and to figure out how to ride out the bad times.

Neil Bendle, assistant professor of marketing at the Richard Ivey School of Business, says the ways in which we make decisions regarding situations like a market drop are learned in childhood.

Bendle's free eBook, Behavioural Economics for Kids, explains this in more detail as he explores certain patterns of human behaviour that begin in childhood and later affect decision-making abilities. Don't let the title fool you; even though the book uses cartoon imagery, it's an insightful read aimed at adults. He explores things like why having two scoops of ice cream instead of one actually matters more for some people than having the actual ice cream.

Here are three theories from Bendle's eBook that are applicable to investment decision-making abilities:

Reference dependence

"We evaluate offerings not on an absolute scale but relative to what we already have (or were expecting). We acclimatize to our current state. What was once a wonderful feature of a product becomes something boring consumers simply expect."

This explains the ice cream conundrum. That fact that you already have the ice cream doesn't matter; it's the additional scoop that you need to have.

For example, if an investor is expecting a 3% return on her portfolio and receives a 3% return, there are occasions where she will feel let down. Even though the result is exactly what she was expecting, it may seem lacklustre. This may help explain why some investors are not content with their portfolios and have trouble sticking with a long-term plan because they are constantly expecting more. Now that they have the 3% return, what more can they get? Unfortunately, this type of investor may never be content unless she gets more than 3%.

Loss aversion

"This basic effect underlies a number of findings. It creates messy asymmetries in economic models. It has been suggested as the reason for the relative expensiveness of safe investments. You effectively pay not to experience the pain of losses which comes with volatile stocks."

People feel the pain of losing something more intensely than the joy of gaining something, says Bendle. Think back to your childhood -- if you had $5 and lost it, but your mom felt bad so she gave you another $5, you may still have been unhappy because sometimes nothing feels as good as that $5 that was originally yours.

This helps explain why some investors have difficulty in a volatile market. For example, if an investor's portfolio drops 14% and an advisor promises that in the next two years the portfolio will rebound, the investor may still not be satisfied. The investor may never get over the sting of losing his original money despite how well the portfolio rebounds.

Sunk cost bias

"People consider sunk costs. People "pour good money after bad," fight on in wars they should abandon and double down on failing projects. Prior investments drive people's new investments, not just the predicted results of the investment."

"Sunk costs are irrecoverable whatever option is chosen, and they are irrelevant to the decision at hand," says Bendle. They are something you've spent money or time on, and since you are vested you feel the need to complete the task. For example, "I need to finish watching this bad cartoon because I've already been watching it for 45 minutes."

This may be why some investors are tied to investment choices that don't make any sense. For example, say an investor puts $15,000 in a gold sector ETF and after a year the fund loses a third of its value. The decision to hold on to the ETF or sell it should be based on whether the investor believes gold has the potential to gain value in the future, but he will tend to focus on the money that has been lost and his need to make that loss feel worthwhile.

Of course it doesn't make sense because the money lost has no bearing on the future potential of the ETF, but people have a tendency to consider sunk cost bias whether they are aware of it or not.

Overall, we are all victims to these types of behaviours and many of them are learned in childhood; it depends on how we grew up, but we all have biases. The goods new is that we all have the ability to overcome them by being aware of them.

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