behavioural finance psychology financial decision making

8/7/2019 Behavioural Finance Psychology Financial Decision Making

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BEHAVIOURAL FINANCE

The Psychology of Financial Decision Making


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Written by behavioural finance experts at Barclays Wealth, itseeks to explain how individual differences in psychologyplay a vital role in all aspects of financial decision making.

The report is based on existing academic literatureintegrated with the proprietary research of Barclays WealthsBehavioural Analytics team.

About this report


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Barclays Wealth aims to provide clients with the means to manage their wealth successfully. For this reason, we are

committed to investing in research that can help expand and deepen our understanding of how clients differ in their financial

decision making, and indeed all aspects of how they manage, grow, protect and pass on their wealth.

Over the past decades, academics and financial practitioners alike have devoted significant resources to trying to identify

investment strategies that are successful regardless of wider economic and financial market conditions. Only a small

percentage of this vast output has been devoted to an area which we view as being fundamental to the successful long-termmanagement of wealth behavioural finance. Behavioural finance uses our knowledge of psychology to improve our

understanding of how individual investors make financial decisions, and how these individual decisions cause markets to

behave in aggregate.

Even though behavioural finance is more popular than it was a decade ago, it is still considered a niche area within the

financial services world. There are few behavioural finance funds or strategies available to individual investors. In the

institutional arena, behavioural finance is slightly more popular, but is still far from being considered a core approach.

This is unexpected, as systematic psychological patterns such as the herd mentality or the tendency for retail investors to

buy investment funds simply because they have performed well in the past are evident in financial markets every day, and

have been documented for decades. Perhaps more fundamentally, it has been clear for some time that the majority of

investors exhibit loss aversion so the pain arising from a loss is felt much more keenly than the pleasure derived from a gain

of equal magnitude. And yet, the majority of traditional investment strategies are based on the assumption that we are all

willing and able to participate in losses to the same extent that we are in gains, with no allowance made for the fact that losses

may have a significantly greater impact both financially and psychologically than gains.

In simple terms, we do not think it is possible to separate an investors personality and the investment decisions that he or she

may make; for us, they are two sides of the same coin. This paper shows how investment and its outcomes, like all human

activity, is ultimately governed by individual biases (the market after all, is the just the summation of thousands of

individual investors views). Individual psychological biases and traits exert significant influence every time we make or chose

not to make an investment decision, and also influence how we view and react to the outcome of those decisions.

Academic research into the psychology of finance has dramatically increased our ability to understand individual financial

behaviour in recent years, but this knowledge has until now been a largely untapped resource in commercial applications.

Barclays Wealth is committed to using this cutting-edge resource in our continued efforts to understand our clients as

individuals when delivering their optimal financial solutions.

Greg Davies

Head of Behavioural Analytics

Barclays Wealth

Foreword


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The myth ofthe average

investor

Modern portfolio theory is

built on the assumption of

the economic investor

a rational being who

wants the maximum

return for a given level of

risk (or the minimum level of

risk for a given level of return).

However, the economic investor is

also presumed to be a dispassionate

individual who is unaffected by

emotions such as anxiety, regret, hope

and fear. The purpose of this article is to

demonstrate that this rational investor

simply does not exist.

Everyone sees the world from a perspective which isuniquely theirs, and investing is no different. People have

individual goals, requirements, desires, fears and hopes for their

wealth. We all have different habits, different people we trust for

advice, and different beliefs about the right decision on any occasion.

But we all exhibit very similar psychological biases in our financial

decision making, which can lead to poor portfolio choices and subsequent

investment performance.


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Understanding your financial personality is vitally important.

It can help you understand why you make the decisions you

make, how you are likely to react to the uncertainty inherent

in investing, and how you can temper the irrational elements

of investment decisions while still satisfying your individual

preferences. In this article we highlight some of the cognitive

traps in investing that most people are susceptible to.

Thinking about these in the light of your own financial

personality report will help you avoid them. Indeed,

understanding your own financial personality and common

investing biases will improve the investment experience for

you from day one onwards.

Improving your Investment Experience

We all want to make decisions to achieve what we believe

will be best for us, and there are many theories about howwe should rationally make these decisions. However, there

is substantial evidence that the decisions we do make are

not the ones that these theories predict we would.

Studies by psychologists and economists suggest that there

are limits to the amount of information we are willing or able

to process. This leads to individuals using heuristics or rules

of thumb to help make better decisions. Many of these

heuristics lead to decisions that are almost as good as

those reached using the best rational option, and often re-

quire far less effort.

Unfortunately heuristics reduce the information that

individuals feel it is necessary to seek out before they make

their decisions, and can often develop into habits that dont

easily fit changing situations. They dont provide the right

answer in every situation. Additionally, people will continue to

use heuristics that have resulted in good outcomes in the

past. This tends to lead to a degree of overconfidence in the

outcomes of decisions when the particular heuristic is used.

How you ask is sometimes more

important than what you ask

Individuals are extremely sensitive to the way in which

decisions are presented or framed simply changing the

wording or adding irrelevant background detail candramatically change peoples perceptions of the alternatives

available to them, even where there is no reason for their

underlying preferences to have changed. Consequently the

framing of questions can often influence the decision that is

made. Consider the options in the problems below:

Problem 1

The government is preparing for an outbreak of an unusual

disease, which is expected to kill 600 people. Two alternative

scientific programmes to combat the disease are presented,

together with estimates of the consequences.

Which should be pursued?

Programme A: 200 people will be saved.

Programme B: A one-third chance of saving 600 people, and

a two-thirds chance of saving no one.


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Experimental studies show that when people are presented

with Problem 1, about 70% choose Programme A. Most

people prefer to know that they will definitely save 200

people than take a chance that none will be saved. The real

insight, though, comes when we compare these responses

to those of a second problem:

Problem 2

The government is preparing for an outbreak of an unusual

disease, which is expected to kill 600 people. Two alternative

scientific programmes to combat the disease are presented,

together with estimates of the consequences. Which should

be pursued?

Programme X: 400 people will die.

Programme Y: A one-third chance that no-one will die, and

a two-thirds chance that 600 will die.

It should be fairly clear that both problems lead to exactly

the same outcomes but that one is expressed in lives saved

and the other in lives lost. Therefore, if people prefer

Programme A in Problem 1 they should also prefer

Programme X in Problem 2 these two choices lead to

exactly the same outcome, 200 people being saved and 400

deaths. However, when experimental subjects are presented

with Problem 2, only 20% choose Programme X! It shows

how easily peoples intuitive choices can be affected just by a

simple rephrasing of the options available.1

The effects of framing can be equally dramatic in an

investment context. Peoples personality traits can hugely

affect the way they react to the actual performance of their

portfolio in the future.

Consider a situation where two investors (Paul and Peter)

have made the same investment. Over one year, the market

average rises 10% but the individual investment value in-

creases by 6%. Paul cares only about the investment return

and frames this as a gain of 6%. Peter is concerned with how

the investment performs relative to the benchmark of the

market average. The investment has lagged behind the

markets performance and Peter frames this as a loss of 4%.

Which investor is likely to be happier with the performance of

their investment? Because of the way that individuals feel

losses more than gains, Paul is much more likely to be happy

with the investment than Peter. Their differing reactions here

will frame their future investment decisions.

Another problematic heuristic is the strong tendency for

individuals to frame their investments too narrowly looking

at performance over short time periods, even when the

investment horizon is long term. People also struggle toconsider their portfolio as a whole, focussing too narrowly on

the performance of individual components. Examples of

these important types of framing are included in the

following section.

1Source: Tversky and Kahneman, 1981.

The half empty/half fullprinciple


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Mental accounting refers to how individuals mentally

integrate different parts of their wealth. For a portfolio to be

correctly aligned to your attitudes we at Barclays Wealth

consider all parts of your wealth, and all the assets you hold.

However, different components of your portfolio may have

quite different risk properties.

Consider the following simplified portfolio:

50% of the portfolio invested in a UK bond index.

50% of the portfolio invested in UK shares.

Suppose that in one year, the UK bond index increases in

value by 10% and the shares component of the portfolio falls

by 5%. Over the year the portfolio would have a 2.5% overall

return. However, mental accounting often prevents

individuals from looking at the change in their total wealth.Instead, they evaluate each component in isolation, and

because they are prone to loss aversion they are likely to feel

the pain of the 5% at least as keenly, if not more so, as the

pleasure of the 10% gain. (Psychological evidence

suggests that most people feel the pain of a loss about twice

as much as they feel pleasure from a gain of the same size.)

So, even though overall you are 2.5% better off than when

you started, you are likely to feel worse off than if that 2.5%

gain hadnt included a loss. The result is that people often

take on less risk than is appropriate because they try to avoidlosses to any single part of their portfolio, rather than

focusing on overall performance.

Over-monitoring performance

can be misleading

How frequently you monitor your portfolios performance can

bias your perception of it. Suppose you were investing over a

5-year investment horizon in a high-risk equity portfolio.

The table below presents how you would perceive the

portfolio depending on the monitoring period.

Over the appropriate 5-year time frame, equity performance

has been positive 90% of the time, and so risky investments

do not lose money more than 10% of the time. However, if

you were to monitor the performance of the same portfolio

on a month-by-month basis, you would observe a loss 38%

of the time! 2

Once again, because of our inherent aversion to loss,

monitoring your portfolio more frequently will cause you to

observe more periods of loss, very likely feel more emotional

stress and take on less risk than is appropriate for your

long-term investment objectives.

Observing short-term fluctuations in the value of an

investment is likely to cause more discomfort for investors

who are particularly sensitive to losses. This may prevent

them from investing in such a portfolio and thus lose out on

the higher potential returns that they would get by taking on

appropriate levels of risk.

2Source: Kahneman and Riepe, 1998.

Keep a broad perspective

Monitoring period

Percentage oftime seeing

5-year period

Gains 90%

10%

62%

38%Losses

1-month period


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Regrets of omissionand commission


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Which would you regret more having missed the

opportunity to buy a stock which went up by 45%, or having

sold the same stock before it went up? People who dont

usually take risks fear errors of commission, i.e. mistakes

because of their actions. Conversely, individuals who have

experience taking risks worry more about errors of omission,

i.e. having the chance to make a good investment and

missing it. It is important to recognise that they have the

same effect upon our wealth, and we should keep a broad

perspective on such decisions.

Because of inflation, small

increases in wealth are

actually losses

Whilst we understand you want to preserve your wealth, we

all have a natural tendency towards money illusion, that is,

taking amounts of money at face value without factoring in

the effects of inflation. This means that not taking on any

risk in your portfolio can actually be risky. Holding your

money in a simple savings account is likely to beat inflation

by barely 0.5% over the next five years. At this rate, 100

kept in a savings account for the next five years will purchase

only 102.50 worth of goods when you withdraw it, even

through the nominal value will be in the region of 116.

In fact, the inflation rate calculated by the government

explicitly excludes affluent families from the methodology.

Many of the goods that wealthier people spend large

portions of their money on are increasing in price much

faster than the rate of inflation. School fees, insurance and

high-end entertainment are increasing by about 7 to 10%

per year rather than the 2 to 3% of the reported inflation

rate.

Your investments need to work even harder to keep pace

with your personal inflation rate and preserve the

purchasing power of your wealth.

If you are holding large portions of your wealth in cash or

very low-risk investments, your wealth may appear to be safe

when compared to the widely reported Consumer Price

Index (CPI) number. However, if, as is likely, your personal

inflation rate is considerably above the CPI, your wealth will

actually be losing value over time. Barclays Wealth can now

provide its UK Private Bank clients with access to a Personal

Inflation Rate calculator, which has been independently

developed by Ledbury Research. This tool can provide you

with an accurate assessment of the inflation rate that you

face across the range of goods that you purchase. This

provides an important guide to the level of returns that your

investments need to achieve just to preserve the spending

power of your wealth over time.

People divide their wealth

equally into smaller pots

When presented with a range of investment options, it is

common for people to use the simple decision rule of

spreading ones wealth equally amongst the availableoptions. As with many heuristics, this is often a sensible

approach as it diversifies the portfolio, obeying the old rule of

thumb of not putting all ones eggs in one basket. It also

helps us to overcome uncertainty about our own preferences

for risk and future returns as it is very difficult for us to

accurately assess how we will feel about a whole range of

possible outcomes in the distant future, and what our own

trade-off between the risk of future loss and higher returns

should be.


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So when deciding how to invest, individuals often place an

approximately equal amount of their wealth into each

investment. However, this also means that the final level of

risk they take on can be heavily influenced by the number of

options they are presented with, i.e. the number of available

baskets for their investment eggs.

For instance, an investor who has five investment options to

choose between may be likely to place one-fifth of his total

investment in each. Thus, if presented with four risky options

and one safe option, the overall portfolio will be fairly risky. If

the investor were instead presented with four safe options

and one risky option, the final portfolio chosen would very

likely be fairly safe regardless of the actual Risk Tolerance of

the investor.

A properly balanced portfolio will lead to portions of wealth

being spread across a range of assets but would be highly

unlikely to place equal amounts in each. Our Risk Tolerance

scale is designed to overcome the potentially harmful traps

that we are naturally prone to in our decision making. In

determining an accurate measure of your Risk Tolerance at

the outset, we can help ensure that your portfolio takes on

the right level of risk no matter what options you are faced

with.

Overconfidence leads to too

many trades

Another decision-making bias that humans are prone to is

overconfidence. Psychological studies show that, although

people differ in their degrees of overconfidence, almost

everyone displays it to some degree. For example, much

more than half the population claim to be above average

drivers, or have an above average sense of humour! There isa tendency for individuals to place too much confidence in

their own investment decisions, beliefs and opinions.

In finance this can lead one to form firm opinions about

where the markets are going on the basis of far too little

information. Asset values tend to have an underlying

trending path but from day-to-day they often move around

in an unpredictable manner. Overconfident individuals take

the unpredictable movements in asset values as affirmation

of their own financial beliefs, and tend to see them as signs

of future trends, rather than just random fluctuations. In

many ways this is natural people are psychologically

hard-wired to find patterns in the world. This frequently

leads to individuals over-trading because of the random

movements in asset values rather than the underlying

fundamentals that determine those values.

For active investors this often manifests itself in making too

many trades. Individuals will tend to believe that their

interpretation of information in the market is correct, even if

in reality it is based on observations of random fluctuations.

If the trades are based on overconfidence and random

signals, then on average they will tend to go neither up nor

down. However, each of these trades costs money, so on

average, over a large number of trades, overconfident

investors lose money. Investing for the longer-term is

frequently a better overall strategy.

The solution to this problem and the others that we have

highlighted is a portfolio which reflects your personal

investing preferences and which helps you avoid the

psychological pitfalls which all of us are prone to. As a wealth

manager, we believe it is our responsibility to make you

aware of these traps and how you can avoid them.

Ultimately, investment decisions like all decisions in life

are subject to our own particular biases and traits. We

believe that recognising these biases and traits and taking

measures to avoid some of the most common pitfalls

results in a significantly more enjoyable and rewardinginvestment experience.


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Whilst every effort has been taken to verify the accuracy of

this information, the information, opinions or conclusions set

out in the report are intended solely for informational

purposes, and are not intended to be a solicitation or offer, or

recommendation to acquire or dispose of any investment or

to engage in any other transaction, or to provide any

investment advice.

Legal note


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Barclays Wealth is the wealth management division of Barclays and operates through Barclays Bank PLC and its subsidiaries.

Barclays Bank PLC is registered in England and is authorised and regulated by the Financial Services Authority. Registerednumber is 1026167 and its registered office: 1 Churchill Place, London E14 5HP.

The services mentioned in this document may not be suitable for all recipients and you should seek professional advice if youare in any doubt. This document does not constitute a prospectus, offer,invitation or solicitation to buy or sell securities and isnot intended to provide the sole basis for any evaluation of the securities or any other instrument, which may be discussed in it.This document is not a personal recommendation and you should consider whether you can rely upon any opinion or statementcontained in this document without seeking further advice tailored for your own circumstances. This document is confidentialand is being submitted to selected recipients only. If you are not an addressee, or have received this document in error, pleasenotify the sender immediately, destroy it or delete it from your system and do not copy, disclose or otherwise act upon any partof it or its attachments. It may not be reproduced or disclosed (in whole or in part) to any other person without our priorwritten permission. The manner of distribution of this document may be restricted by law or regulation in certain countries andpersons who come into possession of this document are required to inform themselves of and observe such restrictions. We orour affiliates may have acted upon or have made use of material in this document prior to its publication.

We are committed to providing equal access to our services for all clients with disabilities. If youwould like this document in Braille, large print or audio tape, please contact your Private Banker.

February 2008.

behavioural finance psychology financial decision making

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