Behavioural Finance: The End of Homo Economicus
Finance is Scary
Financial matters tend to scare a lot of people away: “Finance is all about money and numbers. I don’t have enough of the former and I don’t understand the latter.” At least that is a common impression. The financial advice industry exists in large part for this reason. While we find finance difficult to understand and off-putting, at the same time, we often take great interest in trying to understand ourselves.
Psychology is Fascinating
A lot of money is spent on speaking with psychologists and other counsellors. Unlike our finances, many of us want to learn more about how we “tick.” In efforts to limit the spread of COVID-19, public health officials have mandated social distancing. That has been a challenge for many people. Even for introverts like me, not interacting with others at least occasionally has a negative impact on our mental health. I have been reading and listening to opinions by some education specialists who argue that the negative psychological and developmental consequences of children not going to school far outweigh the physical consequences of contracting COVID-19. People who have lost their jobs struggle with the lack of meaning that productive work brings to their lives.
More recently, we hear about COVID fatigue. This is not the fatigue that is a consequence of the disease; it is fatigue about the aforementioned social distancing and mask wearing. “I just want things to go back to normal,” we might say. And so, we have people packing into pubs, gathering at people’s homes for parties, and creating new centres for outbreaks of the disease. Such actions are understandable, even though they are arguably irrational.
What Economists Like to Think is True
Economists like to think that we are rational creatures. For one thing, their models work better when human economic behaviour can be counted on to make sense. The term Homo economicus was coined to describe this model human being. According to this model, three principles rule human decision-making with regard to economics:
- Perfect rationality
- Perfect self-interest
- Perfect information
But do any of these make sense? Even if they help make economic models work, do you behave this way? Do you know anyone who does?
What drives your behaviour regarding money? When you go shopping at your local supermarket do you pick up only the things that are on your list? Marketers who specialize in retail merchandising know about the impulse shopper so at the end of an aisle you might see a special deal for a product you had no intention of buying.
If you shop online via Amazon, when you add something to your virtual shopping cart you may see on your screen some complementary products that you had not planned to buy, but suddenly seem to make sense.
My architect daughter pointed out to me that shows on HGTV that feature “open concept” redesigns are there not because they necessarily make design sense but so that the shows can attract male viewers who like to watch all the smashing of walls and wielding of sledgehammers. And now we have a trend that favours the open concept because of marketing, not rationality.
We are generally not cool dispassionate intellectuals about making financial decisions. More often than not, we first respond to our impulses like fear, greed, love, hate, pleasure or pain. Rational we are not, or at least not often.
Have you ever donated to charity? Have you ever volunteered your time? If you to a college or university, did you enter a program of study designed to make you the most money or were there other criteria?
Most religions promote selflessness and acts of kindness. Perfectly self-interested individuals would have no use for such behaviour. Similarly, the self-interested would never engage in substance abuse or other forms of self-harm. The fact is most often you will find your friend, your family member or yourself acting in ways that not self-interested.
Although the internet has made it a lot easier to get closer to perfect information, it can hardly be said that we know everything we need to know in order to make the best choice about what to buy. Often salespeople will try to take advantage of that. Speaking personally, I received a phone call from an agency I was personally familiar with, offering me a vacation package that sounded like a really good deal. However, I had to agree to that deal on that day. Given COVID-19, I’m quite reluctant to make any vacation plans. I didn’t have perfect information about the future of my ability to travel. The agent was trying to counteract that situation by offering a good deal. However, I didn’t have perfect information about that either. Was it really a good deal? For the most part, we simply don’t have perfect information, or even particularly good information when we are pressed to make a decision immediately.
Enter Behavioural Finance
Given increasing awareness of the foibles of human behaviour, including in our financial lives, academicians in the worlds of finance and economics on the one hand and psychology on the other, began interacting more deliberately, resulting in new insights in understanding human behaviour in finance or investing.
Investor Psychology: The Sleep-At-Night Portfolio
Investment risk can be assessed in various ways. The following are the three basic components, each of which can be further refined.
1. Required Risk: This is the risk you need to take in order to reach your goal. If you need to generate a 6 percent return over the next 30 years to in order to retire at age 65, then your investment portfolio better tilt strongly toward equities in order to reach your goal.
2. Risk Capacity: How much financial risk can you afford to take? A young woman in her 20s who has just begun saving for an anticipated retirement 40 years in the future has enough time to weather all the volatility the stock market can throw at her. On the other hand, a man in his 60s who is within five years or so of retirement, needs to know that his investment portfolio will be there when he finally puts down the tools of his trade for the last time. He cannot afford to take the same degree of risk that a younger person could.
3. Risk Tolerance: While risk capacity has more to do with an awareness of the inherent variability of stock market returns over the shorter term, risk tolerance has to do with your ability to stomach those swings. This kind of risk has nothing to do with your age and everything to do with your emotions. If you go to an investment advisor who determines that you need to have a portfolio invested in 80 percent equities and that furthermore, based on your age, the stability of your income, and the anticipated timeline when you will start withdrawing the money, etc., you have the capacity to handle an 80% equity portfolio, but you are a very cautious person who cannot tolerate swings in the value of your account, it doesn’t matter what makes sense. You won’t be able to sleep at night and you aren’t going to invest in that risky portfolio.
Risk Tolerance Questionnaires
While investment advisors need to know their clients well enough to recommend a portfolio that they can stick with over the longer term, the important point here is that you need to understand yourself, too. To that end, investment advisors typically use a risk tolerance questionnaire in order to narrow down the type of portfolio that will be suitable for their clients.
Here is an example of an Investor Questionnaire from Vanguard Canada that you may be interested in taking in order to see what kind of portfolio makes sense based on your answers. Be aware, though, that such a questionnaire is just a start in finding your way toward investment decisions.
When we hear that a person in authority is biased, we fear that we might be one of those people about whom the person in authority is biased against. When jurors are chosen for a trial, the initial pool of potential jurors is whittled down until, one hopes for the sake of justice, those selected represent an unbiased group of people who can make a decision on the guilt or innocence of the accused based on the evidence presented in the trial.
It probably comes as no surprise that we approach our money with all kinds of biases, preferences or inclinations. Broadly speaking, biases can be divided into two categories: cognitive and emotional.
Cognitive biases are common errors of memory or information processing. Sometimes cognitive biases are simply shortcuts because we have so much information out there it’s hard to process it all to come to the right conclusion. Some examples:
Mental accounting is the tendency to categorize assets into different, non-interchangeable mental accounts. Ask yourself, do you categorize money based on how you received it? Was it from your employment earnings? Was it a gift? An inheritance? Perhaps a lottery win? If so, do you treat those different sources of income differently? I received a gift of money from someone recently. Because I value that person, I feel like I need to spend it wisely, and not just treat it like the regular money I use for daily living expenses.
Grocery stores are frequent users of framing when pricing their items. A typical example might be “Two for $8.00,” referring to two 500g boxes of cereal It doesn’t necessarily mean that there is a discount for buying two versus only one. And even if there is, you might find that if you look a little bit further you can find a 1kg box of the same cereal at a regular price of $7.00.
If cognitive biases are errors in the realm of reasoning, emotional biases appear spontaneously. They are involuntary feelings or perceptions.
This bias states that on average, loss is twice as powerful a motivator as the possibility of making a gain. In the investment world, imagine being invited to invest $10,000 in a business. You are told that there is a chance that if things go poorly you could lose up to $5,000. If they go well, you could get your original investment back plus up to an additional $5,000. Loss aversion suggests that would not be enticing enough for the average person. Most would say that a risk of loss of $5,000 means I would need to be able to expect $10,000 back in order to go ahead with the investment.
This is the bias that was operating in my recent discussion about investing a sudden financial windfall all at once versus investing it slowly over an extended period. It would feel really bad to invest a $60,000 inheritance in a lump sum only to see the stock market decline by 30% in less than a month. If you invest a little at a time your losses will be relatively minimal and you can avoid feeling a sense of regret over having lost all that money.
Behavioural finance has appeared as a topic in many books, scholarly journals and popular magazines in recent years, so I can only scratch the surface in this already longer than normal blog post. I will come back to this topic next time. If you are interested in reading some more on Behavioral Finance here are a few sources:
Dan Ariely and Jeff Kreisler, Dollars and Sense
Daniel Crosby, The Behavioral Investor
Daniel Kahneman, Thinking Fast and Slow
James Montier, The Little Book of Behavioral Investing
Richard Thaler and Cass Sunstein, Nudge
Jason Zweig, Your Money and Your Brain
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax or legal decisions.