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Volume2 Issue2
BEHAVIOURALFINANCE
HowHidden BiasesMay Lead to
Investment Errors
RonHaik
MBA,CFP,FMA,
FCSI,CIWM,TEP
Vice-President,
InvestmentAdvisory
Services,
CDSPIAdvisory
Services Inc.
Since theadvent of stockmarkets, analystshaveusedavarietyofmetrics
toexamine—and try toexplain—market behaviour. Thesehave included
influences suchas interest rates, inflation, oil prices, economicactivity, aswell
as the fundamentalsof individual companies that lead to investment decisions.
Theoretically, if all peoplehaveessentially the same informationat the same
time,markets shouldbeefficient. That is to say that the sharepriceof acompany
should reflect its actual value (basedprimarilyonanestimationof itspotential
futureearnings), andbuyers and sellers should tradewithinanarrow rangeof
that value.
But that’snotwhat actuallyhappens. Other factors areat play, including
excessiveoptimismdrivingpricesundulyhighat times, or excessivepessimism
that drives themunduly low. Thishas led to someof thedramaticbubbles and
crashes that haveoccurred throughout thehistoryof themarket.
About 40years ago, as economists tried tofigureoutwhy investorsoften
made irrational choices thatwerecontrary to their best interests, some
groundbreaking thinkersbrought anewanalytical tool to themix: behavioural
finance. Behavioural financegained traction in2002whenpsychologistDaniel
KahnemanwonaNobel Prize inEconomicSciences for hiswork in thefield.
Theorists suggestedanumber of cognitivebiases that consistently impact
investment decisions. Someof these include:
• LossAversion
Thenegativeemotionof losingmoneyoutweighs thepositiveemotion
ofmaking it. Studieshave shown thepainof loss is twice that of the joyof
makingmoneyout of an investment, sopeoplemayavoid takinga loss and
hangon toan investmentwhen indicators suggest they shouldn’t.
• Anchoring
Peoplefixateonapricepoint atwhich theybought a stock, or aprice the
stockhadachievedat someprior time, even if circumstanceshavechanged.
Some investors, for example, expect a stock thatwas a star to regain its
brilliance longafter it has fadedand isunlikely to rebound.
• Herding
Investors, including some large institutional investors, tend to followwhat the
other guy isdoing.
