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This article was published 30/4/2016 (2258 days ago), so information in it may no longer be current.
Finance professor Chi Liao’s background in mathematics often comes in handy in her line of work.
After all, both corporate and investment finance are built upon numbers. Yet financial reporting — balance sheets and cash-flow analysis — is not her area of interest.
In fact, her expertise has less to do with the numerical side of money and more to do with how our emotions affect how we manage our hard-earned cash.
"I’ve always been fascinated by people-watching and why it is we do what we do," says Liao, who studied mathematics and finance before completing a PhD in behavioural finance from the University of Toronto in 2014.
Afterwards, Liao — who grew up in Winnipeg — took a position as an associate professor at the Asper School of Business at the University of Manitoba.
And this past fall, she taught the first course ever offered at the school in behavioural finance.
What behavioural finance aims to explain is why, despite our best and seemingly most rational intentions, emotions often still get the best of us.
"As it turns out, a lot of smart people do funny things when it comes to their investments."
Much of this can be boiled down to biases, Liao says. These are implicit prejudices we hold about money that lead to thinking errors we’re unaware we’re even committing because we’re under the assumption we’re acting rationally.
But in reality we’re not.
While it’s important for business students to understand these potential biases and their impacts, it’s also helpful for Joe and Jane Public.
And much of Liao’s research examines how average investors’ decisions are influenced under certain conditions.
Her PhD thesis, for example, studied the impact on investors who live in close proximity to casinos.
"After a casino opens, investors who are likely to gamble will also take on more risk in their stock portfolio compared to people who are unlikely to gamble," she says. "For whatever reason, when you go to the casino — and on average people lose — then you might, because of your loss, increase your risk-taking in your stock portfolio."
Liao says other psychological studies offer insight as to why this might occur.
"It could, for example, be because casinos are intentionally set up to induce excitement, and positive emotions and excitement have shown in psychology literature to increase risk-taking."
Moreover, her work found for those who didn’t gamble at all, a casino had no impact on their portfolio.
Liao’s research in this area is ongoing. In addition to the findings of her doctoral research, her more recent research has found a surprising upside to casinos’ impact on investors who gamble at them.
Contrary to what one might assume — that a casino would hurt the portfolio performance of investors who gamble — early results seem to indicate the opposite. Gambling investors actually see an increase in return on their investments when a casino is nearby.
On closer examination, this might not be all that shocking given the fundamental premise of asset pricing is the more risk you take on with an investment, the better the potential return you should receive when the investment does well.
Yet Liao says there are many other factors that have little to do with stock market risk — or casinos for that matter — that influence our appetite for risk when managing our money.
"Right now one of the projects I’m working on is how childhood experiences affect how much risk you take when you grow up and participate in the stock market," says Liao.
While the final results are still pending, she has found so far people who experience financial difficulties in childhood — like a parent losing a job — are less apt to take on risk in their investment portfolio.
While not entirely surprising, it reveals a potential problem for these individuals because their past experiences may overly influence how they measure investment risk. And consequently, an individual may decide to avoid investing in the stock market altogether.
Given the general lack of job security, diminishing access to defined-benefit pension plans and rock-bottom returns on risk-free assets such as GICs, this attitude could negatively impact their long-term ability to save for retirement. The fact is investing in the stock market is almost unavoidable for investors seeking to build wealth, Liao says.
"Investing in the stock market contributes, on average, a great deal to wealth accumulation over your lifetime, so if you abstain from the stock market it’s very possible you will not have enough wealth accumulated by the time you retire."
Of course, people can abstain from the stock market and still end up with enough loot to retire. But this strategy, too, involves risk.
"If you’re investing in something that is low-risk, the chances are that capital will be there when you retire," she says. "You can save more, but what is that money you’re saving doing?"
That money is likely growing very slowly and exposed to another form of risk.
"We all know inflation is going to happen, so in that sense it’s not risky," she says.
"The risk would instead be how high inflation might be and what happens with the economy."
Yet just because stock markets may now be a necessary risk for many investors doesn’t mean we can’t mitigate the risk.
Diversification, for example, across geographies, markets and assets can help reduce portfolio over-concentration risk (that we might have too many eggs in one basket).
Investors should also lean toward emulating market performance through low-fee — index mutual funds or exchange traded funds — instead of trying to beat the market on their own or by paying high fees to fund managers.
"On average it’s very rare for a particular fund manager to continuously beat the market, and if they do exist, they can be very hard to identify," Liao says.
The best strategy, she adds, is often one that removes as much as possible our biases from the investment process so we don’t end up making decisions that wreck our portfolios despite our best intentions.
It’s a prescription even Liao herself ascribes to for her own investments.
"I just buy and hold a portfolio of well-diversified ETFs and funds," she says. "I know I’m susceptible to biases, too, so I’ve modified my investment strategy to take that into account."