Foundations of Behavioural Science 

Warning: Psychological biases dangerous to your wealth

Behavioural scientists have identified many psychological biases that may interfere with rational decision making. Below, we discuss a few of the more important ones and their implications for making smarter financial decisions.

1.Prediction addiction

We have an in-built addiction to predict that is almost hardwired into our brains. Thousands of years of evolution have honed our biological need to detect and interpret patterns. We hate randomness and we have a compulsion to make predictions about the unpredictable. Our brains seek patterns automatically and most of the time this is occurring outside of our awareness. 

Scientific experiments have confirmed this compulsion. Even when told that the future outcomes of an experiment are purely random, we continue to try to figure out a pattern. And the more time we spend trying, the more convinced we become that there is a pattern.

It’s understandable then that it’s not that easy to break this addiction. The more effort and time we spend on trying to work out patterns, the harder it is to let go of this pattern seeking behaviour.

In his book, Your Money or Your Brain, Jason Zweig refers to studies done by neuroscientist Hans Brieter of Harvard Medical School. Brieter compared the brain activity of cocaine addicts who were expecting “a fix” with people who were expecting to make a financial gain. He found that the similarity in brain activity between the two was indecipherable.

When we experience two or more investment “wins”' in a row, we can become as hooked as a cocaine addict. It's not the thrill of making the money that causes this “high”, it’s the thrill of discovering a pattern. It sets off a release of dopamine in the brain that we become addicted to.

So, those who claim they know where investment markets are going are being driven by their unconscious desire to find patterns in market behaviour. And, the more effort and time that they put into this pursuit the more convinced they become that there is a pattern and they will discover it. 

We understand this obsession. Breaking the prediction addiction is not easy. It doesn’t come naturally – it takes effort and discipline. The more you give into the addiction, the more difficult it is to let go. And, while it may appear more enjoyable in the short term, it's robbing you of the outcomes you could more easily attain from using a more considered and disciplined approach that does not rely on the ability to predict.

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2.Hindsight bias

Hindsight bias is the tendency to judge decisions by looking backwards. It is generally neither objective nor very useful. It compares decisions made under uncertainty by someone who cannot know the future with decisions made by someone with an infallible crystal ball.

So, before the event you don't believe in crystal balls and after the event you do. The decision maker should surely have foreseen what transpired – it’s so obvious now.

This is not an intentional bias. It is part of the cognitive dissonance process that helps us to feel as smart as we like to believe we really are. It's a bit of trick we play on ourselves. By feeling smarter about our past decisions, we feel more able to cope with the decisions we make in the future.

Unfortunately, this delusion often means that we enter decisions thinking we know more than we do, leading to poorer decisions (see over-confidence). 

"Hindsight bias makes surprises vanish. People distort and misremember what they formerly believed. Our sense of how uncertain the world really is never fully develops, because after something happens, we greatly increase our judgements of how likely it was to happen".
- Daniel Kahneman, psychologist

The most common form of hindsight bias that we experience is the financial market commentary made at the end of the day. As the “experts” describe with the greatest of confidence why the market behaved as it did, you could easily infer that the behaviour of the market was so reasonable that it could have been predicted earlier that day.

This simply reinforces hindsight bias, detracting from your ability as an investor. Watch the evening commentary by all means, but remember that these “experts” have no crystal ball to explain what will happen tomorrow.

All decisions must be made looking forward, not backward, and investors will always be faced with uncertainty when making decisions. The best approach is to accept that uncertainty abounds and make decisions anyway. If you're waiting for uncertainty to disappear you may end up waiting forever, or at worst deluding yourself that it has disappeared.

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Regret is the pain experienced when the outcome of a decision is adverse. Holding on to feelings of regret can damage your future decision making. It adds a layer of emotion that is neither healthy nor optimal for making good investment decisions.

Unfortunately, you cannot turn the clock back. What has happened has happened and the only rational and sensible course of action is to get on with life. Let go of what could have been, accept where you are now and start asking yourself the question, "If I had a blank sheet of paper, what course of action would I now take?"

Part of moving forward may involve a review and refinement of your prior decision making process. But avoid the temptation to throw the whole process out the window. Challenging and refining your existing process is the best place to start.

Identifying a mistake is often not straightforward. Not all rational, well considered decisions result in the outcomes you hope for. Just because you don't get what you expect does not necessarily mean that the decision process was faulty.

Imagine playing roulette at the casino. For the sake of the example we'll assume that the odds at this casino are fair (otherwise you wouldn't play at all, right?). You decide to take a low risk option of betting on red or black. You know the odds for each are the same, so it really doesn't much matter which colour you choose. You opt for red. You win the first bet and lose the next three bets. Does that make the decision making process a poor one? Do you now choose to bet on black? You may regret your decision to choose red but that doesn't make it a bad decision.

People prone to regret often blame the decision. Unfortunately, this can lead to a lack of responsibility with future decisions or, worse, “decision paralysis” i.e. inaction for fear of making a mistake.

If you are prone to wallow in regret it may be that you suffer from “counterfactual thinking”. This term describes the imaginary process of creating “what might have been”. It only helps to embed the feelings of regret and often immobilises investors, resulting in portfolios that control them rather than the other way around.

This kind of thinking can lead to an expectation of regret and expecting regret often hurts worse than experiencing it. You can end up hurting yourself more in the long run by avoiding risks that you think you may regret rather than the actual hurt of regret you would feel from undertaking those risks. Harvard psychologist Daniel Gilbert concludes that under these circumstances people end up "buying emotional insurance that they do not actually need".

The level of regret can also differ for acts of commission (something we did) compared with acts of omission (something we didn't do). 

Imagine two investors. Paul has shares in company A and during the past year has considered switching them to company B, but decided against it. He now realises that if he had switched he would have been $20,000 better off. George owned shares in company B but last year he switched them to company A. He now finds that he would have been better off sticking with company B - he is $20,000 worse off. Who is more upset?

Most people agree that George is probably more upset than Paul. Why? Because George created a loss by something he did and Paul created a loss by something he didn't do. We feel more pain of regret from things we do than those we do not do.

Yet, the best investors are those who act proactively (not reactively). Disciplined investing requires you to make decisions when they can be easily be avoided by doing nothing. You act according to your long term strategy, even if there is nothing “forcing” you to act.

To become this type of investor, you have to recognise that making a decision when one is not required is more an act of commission. Human behaviour indicates that these are the tougher decisions to make. They come linked with a higher level of regret.

If you recognise this trait, you are more likely to be able to overcome your inbuilt desire to defer decisions. While it takes more effort, we believe that you will benefit from a more proactive stance.

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Confidence is a good thing. It promotes self esteem and generally provides us with a positive outlook on life. But over-confidence is another matter. Unfortunately, we are a little predisposed to being over-confident about our abilities.

When asked to assess the likelihood of success of a project when it relates to others, we tend to be quite objective. Yet, when we assess our own chances of success for the same project our judgment is noticeably impaired (towards the upside).

Psychologists have demonstrated that people are consistently overconfident regarding their ability to predict the likely range of outcomes of a particular variable e.g. tomorrow’s maximum temperature, sharemarket returns for the next 12 months etc. There are two groups of professionals that do not demonstrate this overconfidence. They are meteorologists and race track handicappers. Both display the following characteristics:

  • They assess the likelihood of outcomes on a daily basis;
  • They make explicit predictions based on objective probability; and
  • They obtain quick and precise feedback on the outcomes.

From an investment perspective, over-confidence tends to manifest itself in the form of over-estimating your actual portfolio performance, which may then result in unrealistic expectations about your future performance. This often leads to a misunderstanding and poor assessment of the risks you are prepared to take.

In his book, "Your Money or Your Brain", Jason Zweig describes a study of 80 investors to see how they rated their portfolio performance versus the market. Nearly a third claimed their funds had beaten the market by at least 5%, and one sixth claimed they had outperformed the market by 10%.

When their portfolios were compared to the market, it turned out that 88% of the investors had exaggerated their returns. More than a third of those that thought they had beaten the market had actually underperformed the market by more than 5%, and a quarter of them lagged the market by at least 15%.

"Everyone wants to believe they're special and better than average. They think they can beat the market with their own special something. And it's remarkable how this illusion persists even in the face of evidence to the contrary".
- Don Moore, psychologist of Carnegie Mellon University.

Over-confidence also leads to the delusion of control. We like to think we have more control than we actually do. When a group of people were each given a lottery ticket at random and then asked if they would willingly exchange it for someone else's, the majority of people resisted. Many would only part with their ticket for some additional compensation.

Despite the fact that the tickets were distributed at random and each had an equal chance of winning, the participants felt that their ticket had more chance of success than other tickets. Not surprisingly, this delusion of control over random events often clouds our decision making.

Recognising that over-confidence is something we're all prone to is critical to making better investment decisions. Whenever you're making an investment decision we recommend that you ask yourself the following questions:

  • What if I'm wrong?
  • What specific reasons do I have to believe that I know more than the market?
  • How would I act if the market was based on random factors?

You may still proceed with your action but it may help to reduce the degree over-confidence inherent in most of our investment expectations.

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Herding is essentially “running with the pack”. We naturally love to herd - it’s instinctive. Just as a wild animal is driven to place itself in the middle of the herd when under attack, we strive for the safety of numbers. But it can lead to some bizarre and irrational behaviour.

While not recognised at the time, some herding behaviour seems like absolute insanity with the benefit of hindsight. It's the reason we have booms and busts. Our history has been littered with herd driven manias, including Tulip Mania in 1630's, the South Sea Bubble in 1720's and more recently the Tech Boom in the late 1990's.

These manias have all displayed three common human characteristics:

  • People place far more meaning on price than value. The "greater fool theory" abounds. In other words, it does not matter what price you pay as long as there is an expectation that someone else (a greater fool) will pay more than you have;
  • People's fear of the regret of missing out is so much greater than the risk associated with participating. This is their once in a lifetime opportunity to get rich quickly; and
  • There is an overriding belief that the world has changed and that the new trend will last forever.

Studies reveal that peer group influence explains a significant amount of herding behaviour. Accuracy levels in one research test declined from 84% to 58% after the introduction of peer influence.

The pain of social isolation for most people is far too big a burden to bear, yet the safety of the crowd is often illusory and can result in catastrophic outcomes. 

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6.Loss aversion

Basically, we hate losses more than we love gains. For this reason, we need to be compensated disproportionately more for holding riskier assets than for holding safer assets. This disproportionate aversion to losses, while perhaps understandable, is a little irrational.

For example, I offer you a “no lose” proposition involving the toss of a fair coin. You get to call the toss. If you're right, you win $1,000 and if you're wrong you get nothing. What would you be prepared to sell this opportunity for?

We know that the expected value of this opportunity is $500 (i.e. $1,000 x 50%), yet most people would accept less than $400 in exchange for it. 

Behavioural economists believe that we weight possible losses 2.5 times more heavily than possible gains when pricing shares versus bonds. They argue that loss aversion largely explains the generous long term premium of share returns over cash, which financial economists consider to be a “puzzle”.

Loss aversion also explains the reason we prefer to sell assets that are in gain rather than those in loss. It has also been suggested that this has a strong influence on the “endowment effect” - that is, people's tendency to place higher values on goods that they own compared to the price they would objectively pay if buying the same goods from someone else.

Understanding our tendency to overweight losses relative to gains can help you to make smarter financial decisions.

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Framing refers to the frame of reference you use to look at a problem or decision. The way you frame your decisions will affect the quality of the decisions that you make. This can have a big impact on your outcomes.

Most of us have a tendency to break down decisions into separate, easily digestible frames of reference. This process is known as 'narrow framing' and is one of the more damaging behaviours we exhibit.

Here are a few of examples of this process in action:

  1. You are worth $1 million and have the following decision to make. You can choose to do nothing or you can opt take a risk which is estimated to return $5,000 if you win, but will cost you $3,000 if you lose. The chances of a win are 50%. Would you do nothing or take on this risk? Think about how you would respond to this offer.

    Now, imagine that the decision was framed slightly differently. You can choose to do nothing, in which case your wealth remains at $1 million, or you can choose to take on a risk which will give you a 50% chance that your wealth will be $1,005,000 and a 50% chance that it will be $997,000. Does this alter your decision?

    For most people it does. Studies show that we are more inclined to rationally view risk when it is framed more broadly, in terms of your overall wealth, rather than when it is focused on the isolated gain or loss.
  2. Considering financial decisions in the broad context of total wealth, rather than in isolation, often opens up the opportunities for natural hedging, diversification and self-insurance that are otherwise wasted. An example we see all too often is the use of internally geared managed funds when the client is simultaneously holding substantial cash resources. In isolation, the use of the geared fund may appear an attractive decision yet when viewed in the broader context of overall wealth is not a smart decision at all.
  3. You are told that over monthly periods, shares have risen 62% and fallen 38% of the time, with the average monthly rise being 103% of the average monthly fall. You choose to determine your allocation between cash and shares at the end of every month (a very narrow time frame). How would you allocate your resources each month?
    • A loss-averse investor with a one-month time frame will not like this gamble. They will be inclined to avoid the risk each month and choose to allocate all of their assets to cash (one month at a time, forever).
    • Now imagine that you choose to determine your allocation between cash and shares at the end of every 5 year period. You will commit to your allocation over each 5 year period no matter what the outcome during that period. Over 5 year periods, shares have risen 90% and fallen 10% of the time, with their average 5-year rise being 158% of their average 5-year fall.
    • How would you choose to allocate your resources under this broader frame of reference? Even a loss-averse investor would find these odds pretty appealing and would be likely to allocate at least a portion of their assets to shares.
    • The only difference in the above is the (time) frame of reference, and this can greatly affect the decisions made (even though the underlying aversion to risk is the same). Taking a broader time frame helps to make this a more rational decision.

Most of the problems associated with poor framing arise from:

  • A desire to simplify the decision making process by coming at it from a bottom up perspective, rather than via a methodical top down process; and
  • The need for more (perceived) control by making more decisions, more often rather than taking a longer term perspective and allowing the exposure to risk to work to your favour.

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8.Undervaluing the future

An emerging trend in society is the need to have things now. But our ability as individuals and as a society to delay gratification and pursue future goals is a vital part of a healthy society.

In his book, "Emotional Intelligence", Daniel Goleman writes of an experiment done with 4 year old children. A teacher offered the children a marshmallow, which was placed on the table in front of them. She then explained that she was to leave the room and offered them the chance of a second marshmallow if they could resist eating the first marshmallow until after she returned.

Some children ate their marshmallows immediately after the teacher had left the room, others waited valiantly but finally caved in. A number managed to delay until the teacher returned and were rewarded with a second marshmallow. The experiment measured the children’s ability to overcome their emotions and resist the temptation for instant gratification. At the same time, it also revealed their ability to be patient to achieve a goal.

The children involved in the experiment were tracked down after they graduated from high school. Compared to the less patient children those who controlled their impulses at age 4 were found to have better SAT scores, were better able to handle frustrations and stress, were more willing to embrace and pursue challenges, and were still able to delay gratification to achieve their goals.

We have a natural human tendency to prefer smaller payoffs now compared with larger payoffs later. This comes largely from a poor ability to value future dollars relative to today's dollars. The further we look into our future the more uncertainty we see.

As a result, we reduce the importance of the future in our decision making and over emphasise the present. We tend to over commit to what we can achieve in the future and under estimate the effect of today's actions on the future. This phenomenon is known as “hyberbolic discounting”'.

If I was to offer you $50 today or $100 tomorrow, you'd probably opt for the latter. However, as the time frame between the two options increases, the choice becomes more difficult. For example, if I deferred the $100 option until one year from now, which would you prefer? Statistically, the majority of people choose the $50 option.

Over longer periods of time, however, we begin to lose our ability to devalue or discount time meaningfully. For example, most people would prefer $100 in 10 years time over $50 in 9 years time. This is contradictory to the decision made for one year out.

The result of all of this is a natural tendency to overweight the short term at the expense of the long term. The end outcome is often short term happiness and long term disappointment. 

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9.Mental accounting

Mental accounting occurs when we categorise our assets into separate, non-transferable “accounts”, rather than viewing them as part of a whole. It results in treating what are essentially identical assets in quite contradictory ways. An example may help explain.

Imagine you have decided to go and see a play this weekend. To save time you pre-purchase your $100 ticket. On the evening of the play as you are about to enter the theatre, you reach into your pocket and find that you have lost your ticket. If you still want to see the play, you have to pay another $100 for a new ticket.

If you are like most people, you would probably think twice. You may still pay the money, but you will now feel that you paid $200 for a $100 play.

Now let's construct the scenario differently. You are going to a play. As you stand in line at the box office to buy your ticket, you discover that you have dropped a $100 note on the way to the theatre. You are disappointed, of course, but would this affect your decision to buy the ticket? If you are like most people, you may feel bad about the lost money, but it probably won't affect your decision to buy the ticket.

Psychologists once conducted an experiment along these lines. They found that only 46% of those who lost a ticket were willing to buy a replacement ticket, whereas 88% of those who lost an equivalent amount of cash were willing to buy a ticket. Since the lost ticket and the lost cash had the same value, their loss should have been experienced in the same way. Yet nearly twice as many people were willing to ignore the lost cash, but not the lost ticket.

Most people treat “found money” quite differently to their own money. Employees of a publishing firm were in the Bahamas for an annual meeting. They were each given a cash bonus of $500 for getting a big contract. Almost all of the bonus recipients took their money to a local casino and blew it.

What is interesting is that most of these people did not lose more than the $500 - they slowed down or stopped when they felt they were playing with their “own” money, rather than with the $500 of “free” money. The irony, of course, is that the $500 these people lost was their own money too.

The most common examples of mental accounting involve the separation of savings accounts and loan accounts. It is quite common for people to build up a separate savings account (say, a holiday account) while maintaining an expensive credit card debt facility. This is great for the banks, but expensive for the customer.

Mental accounting can lead to some fairly irrational decisions. Simply being aware of it and focusing on the “big picture” can help you make smarter decisions.

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Anchoring refers to the disproportionate weight given to a largely irrelevant bit of information when making a decision. It is something we unconsciously do that influences our choices. The anchor itself often has no meaningful link with the decision you are making yet has a powerful impact on your choice. An example will help explain this concept:

A 1970's study by Amos Tversky and Daniel Kahneman (both behavioural psychologists) asked people to guess what percentage of United Nations membership was made up by African nations. However, before each person guessed they were asked to spin a wheel which included the numbers from 0 to 100. They were then asked if their guess was higher or lower than the number they had spun.

Even though the number on the wheel was completely unrelated to the percentage of African nations in the UN, it had an influence on the guesses. The higher the number spun, the higher the guess. On average, those who spun a 10 guessed that African nations made up 25% of UN membership, while those who spun a 65, guessed that they made up 45% of the UN.

Similar studies have shown similar outcomes. In investing, anchoring occurs quite frequently. Despite the fact that the share market is a continuum, we anchor to the closing prices at the end of the day, week, month, year, etc. We also anchor to the highs and lows of the market even though we were not prepared to act at these levels.

In June 1998, AMP Limited floated on the sharemarket. During a frenzied first day of trading as institutions scrambled to get their share of the new company the shares traded as high as $45. They eventually settled to finish the day around the $20 mark.

Even though there were only a limited number of shares traded at $45, many investors became anchored to this unlikely value. This almost certainly resulted in some poor future decision making with respect to their AMP exposure. (N.B: The price has never risen much above the first day closing level).

The most common anchor in investing is the cost of an investment. When faced with a decision to sell one of two investments, invariably an investor chooses to sell the investment that is trading above its cost rather than an investment showing a loss. This anchoring focuses attention on the loss and given our preference for loss aversion results in a less than rational decision.

To overcome the anchoring bias when considering the reduction or disposal of an investment, we encourage you to ask the following question - "If I had a blank sheet of paper today, how much of this investment would I hold as part of my portfolio?" This will help you address the decision from a more rational perspective.

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