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Expert errors

Behavioural finance shows psychology can steer pros wrong

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Investment finance has a long history of calamitous mistakes costing billions, even trillions of dollars.

But we shouldn't be all that surprised when experts flub it up, recent research suggests. After all, they're just like everybody else. We all make mistakes, yet it's the very fact these professionals are so proficient that can make them prone to making serious errors in judgment, says a renowned expert in behavioural finance and president of a major U.S. institutional investment firm.

"The base issue is people tend to be too overconfident with too little data, or that data are misconstrued or it's bad information," says Arnold Wood, with Martingale Asset Management, and a faculty adviser for Harvard University's John F. Kennedy School of Government study on behavioural finance and decision-making.

Wood has been studying behavioural finance for several decades. It's a field of research seemingly at odds with the predominant economic theory about markets being efficient -- that is, that the fundamental values of commodities, bonds, stocks and other publicly traded securities are known and priced accordingly, based on all data available to investors. And when securities are valued incorrectly, the market soon rights itself. Wood says the theory works well for the most part but, as many investors know all too well today, actual experience shows markets can often be anything but efficient.

Enter behavioural economics, developed in the 1970s by behavioural psychologists Dr. Daniel Kahneman and the late Dr. Amos Tversky. They argued humans are emotional creatures and markets -- being human creations -- are prone to being just as irrational as they can be rational.

Kahneman won the Nobel Prize in economics in 2002 for the pioneering work, and his most recent research investigates why we make errors in judgment that lead to dire, often unforeseen consequences.

His latest work is the basis for his New York Times bestseller Thinking, Fast and Slow and was the centre of a lecture he gave last month in Chicago at the CFA (Chartered Financial Analyst) annual conference.

Kahneman contends we think in two ways. One is quick, allowing us to process the multitude of data we're bombarded with immediately so we can seamlessly interact with our surroundings. The other is 'slow thinking' that involves much more conscious brainpower.

He described the difference between them as solving 2 plus 2 versus 257 divided by 28. One answer we know right away; the other requires more time and thought. Kahneman found fast thinking -- called System 1 -- can often interfere with System 2 or slow thinking, and the more familiar we are with what we're thinking about -- call it expertise -- the more likely it is we may not even realize we're making a snap assumption that could be erroneous.

Wood, who was the moderator for Kahneman's talk, says the investment industry is particularly prone to this potential problem because it's built on expertise that tries to predict the future, which is anything but certain. It's also an industry that attracts confident, optimistic individuals. This can make for a bad mix.

"Humans want to see patterns," Wood says, whether those patterns are real or merely perceived.

"It's very scary what people can want to believe they're seeing."

Kahneman says figuring out by ourselves when our fast thinking circumvents the more careful and often correct slow thought processes is difficult.

That's why it's important to challenge our own ideas -- even when we're certain they're correct -- and to vet them with others in an atmosphere where challenging others' ideas is encouraged (which isn't often the case in corporate culture).

"Money managers should be asking all the time: 'When and where do I think this idea is going to turn on me?'" Wood says.

For the average investor, understanding the spectrum of consequences of an investment choice is even more difficult. We rely on data from professionals, including securities analysts.

Bob Dannhauser, head of standards of practice at the CFA Institute, says many of the points outlined in its recently launched "Integrity List: 50 ways to restore trust in the investment industry" touch on addressing this problem, such as promoting transparency with clients about the potential for being wrong, allowing constructive criticism within organizations and helping clients focus on risk as much as performance.

The organization is urging all investment firms to sign on publicly to adhere to the list because people won't invest if they have no trust in the integrity of the industry.

"That's problematic because it's difficult to grow your savings to reach your goals if you're out of the market," he says.

The list may be good medicine for industry professionals, but what about average folk?

Wood says one remedy is focusing less on returns and more on reducing volatility. Low-volatility investments -- such as blue-chip stocks -- have been generally less affected by the grand mistakes of recent market history.

They pay dividends, though they won't make you instantly rich. But instant riches aren't the goal of investing. Slow and steady earnings are, he says.

Another way to reduce the impact of your and others' missteps is to look at your portfolio asset allocation differently. Dr. Ashvin Chhabra -- another keynote speaker at the CFA conference last month -- has combined behavioural economics and efficient-market theory to build a framework for a portfolio with as much in common with Maslow's Hierarchy of Needs as modern portfolio theory, which focuses on diversification in stocks, bonds and sectors.

"My work advises people to think of their portfolios in relation to their essential goals and aspirational goals -- those being the things they must achieve and those they want to achieve in life."

Chhabra says this new portfolio consists of 'three buckets': the safety bucket you need to live -- your home -- which really produces no return; the market bucket (investing in stocks and bonds) and the aspirational bucket, such as starting a business.

"The safety one gives you zero return, but it protects you in the short term," he says. "The market bucket helps you keep up with your peers over longer periods of time."

The aspirational bucket is what you do in life -- those goals that may or may not work out, but they also can provide wealth mobility. You can do very well or, just as likely, flop.

Chhabra says we run into problems when we mistake one bucket for the other, such as believing the stock market will make us rich, or placing our homes in something other than the safety bucket, like borrowing against them to buy speculative real estate.

Of course, the problem is -- given the latest, aforementioned behavioural research -- we might not realize we're erring in the first place.

But Chhabra says this new portfolio structure is really designed to help avoid these mistakes and instead create peace of mind.

"For the average person, they should really think about 'How can I build a portfolio where I can go to sleep at night?' " he says. "That's what's going to make you happy in the end."

CORRECTION: Last week's Money Matters erroneously stated TD Canada Trust and Steinbach Credit Union reimbursed Jack Wladyka's defrauded clients. Manitoba Securities Commission chairman Don Murray says TD Canada Trust and Dundee Wealth Management, the company that employed Wladyka, paid back victims. Murray says this distinction is important because Wladyka was employed by a registered dealer that carries insurance for these kinds of problems. "If Wladyka hadn't been a registrant, the money would likely never have been recovered."

Common biases lead to investment goofs

Daniel Kahneman and Amos Tversky are pioneers in behavioural economics. The psychologists developed prospect theory, which asserts people are more likely to take on risk when looking at the possible rewards they might reap as opposed to what they may lose, and vice versa, even if the potential outcomes are the same. Over the following decades, Kahneman, Tversky and other experts in the field have discovered other types of erroneous thinking patterns that seep into financial decisions. Winnipeg investment analyst Alan Fustey, author of Risk: Financial Markets and You, offers up a few common biases leading to investing missteps.

Availability bias: We are influenced in our decision by what is most current, dramatic and personally relevant. Investors often buy or sell stock based on recent news in mainstream media because that information has the appearance of being the most reliable. For example, this bias can lead investors to buy at the top of bubbles and sell as they burst.

Representativeness bias: We use stereotypes all the time to make sense of our world, but we also know they can be misleading, Fustey says. We run into problems when we forget they're stereotypes. For instance, investors may look at Google's stock performance and assume Facebook -- because it's in the same sector -- will perform the same way.

Overconfidence bias: We all need a certain dose of confidence to do whatever it is we do, but too much confidence can spell trouble. People can often overlook facts because they're overly confident in their own assessment of a situation -- which may be erroneous.

Hindsight bias: Hindsight is 20/20. But it can't predict the future. The problem is we often forget that. "Once you learn what occurred, you look back and believe that you knew all along that the result was going to happen," Fustey says. "This encourages individual investors to view financial markets as being more predictable than they really are."

Risk/loss aversion: This is central to prospect theory. We naturally are more averse to market losses than we are attracted to market gains. But that doesn't necessarily mean we always make a less risky choice. We can get mixed up, thinking we're being less risky when we're actually engaging in risk-taking behaviour. For example, when presented with a choice of a 10 per cent certain gain on an investment versus a 50-50 chance of a 20 per cent gain or nothing at all, most people choose the 10 per cent gain. That's risk aversion. But when presented with these same numbers only as losses, things can get muddled. You can choose a guaranteed loss of 10 per cent or a 50-50 chance to lose 20 per cent or nothing at all. Most people choose the second option. This is risk-seeking, but driven by an aversion to loss.

Mental accounting: A dollar is a dollar, except to our brains. We often assign different values to money. A good example of this bias is saving money for emergencies in an account earning less than two per cent while carrying a debt charging a higher rate.

Republished from the Winnipeg Free Press print edition June 2, 2012 B11

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