How behavioural finance impacts retail investors?
We investigate ten ways in which behavioural finance impacts retail investors due to their irrational biases when making investment decisions.
We take a look at how these factors lead to the establishment of sub-optimal investment portfolios.
We also analyse how this detrimental effect on long-term returns is compounded by frequently poor market timing decisions, based upon irrational factors.
Behavioural finance helps explain why Australian direct retail investors are under-exposed to certain asset classes and worryingly over-exposed to others that offer poor risk-return trade-offs.
“It is true that from a behavioural economics perspective we are fallible, easily confused, not that smart, and often irrational. We are more like Homer Simpson than Superman. So from this perspective it is rather depressing. But at the same time there is also a silver lining. There are free lunches!” – Dan Ariely
What is behavioural finance?
According to Shefrin1, “Behavioural finance examines the biases that investors (individual and professional) incorporate in their investment decision-making process. These biases lead to inefficiencies in market pricing.”
1) Home bias
Investors across the globe have a tendency to over-invest in their home market.
This is perhaps unsurprising as investors have a greater knowledge of local brands and investment opportunities than those further afield.
A rather extreme example is Australian direct investors’ preference for establishing all or most of their equity exposure via shareholdings in large Australian companies.
This is despite the Australian share market making up less than 2% of global shares.
2) Mental accounting bias
Behavioural finance impacts retail investors who are prone to creating mental distinctions that are entirely unsupported by mathematics.
This is closely linked to prospect theory that describes how the pain of crystalising a loss hurts more than the happiness of realising an equal gain.
Realised and unrealised profits (or losses) are perceived quite differently. A key to successful investing is the habit of running profitable positions but cutting losses early. An inclination to ‘book a profit’ or a fear of ‘materialising a loss’ will work against this principle.
Similarly there is mathematically no impact on total return whether the source of return is income or capital growth, (ignoring tax for now).
3) Anchoring bias
The unwillingness to cut losses is reinforced by a psychological factor that tends to be stronger with retail investors.
The rational investor does well to dispassionately analyse a stock’s future prospects using fundamental analysis. However many are distracted by the psychological anchor of their own purchase price.
This leads to a reluctance to exit a falling stock that offers no reason to continue to hold it (see 2), and worse, can even lead to further purchases as it “now looks cheap”.
Anchoring may well have contributed to Australian retail investors maintaining investments in commodity stocks and instruments well into the recent China slowdown. Institutions had often cut their losses much sooner.
4) Overconfidence bias
Many studies reveal that almost all male drivers believe that they are ‘above average’ – clearly mathematically impossible. Behavioural finance impacts retail investors who similarly tend to overestimate their ability to out-perform their chosen market.
The minority of successes glow in the mind long after the majority of poor decisions are discarded from investors’ memories.
This may offer a clue as to why ETFs have been slow to grow market share in Australia.
5) Attention bias
The part-time investor is especially influenced by the information set that they study.
Hence Australian readers of the national press and domestic investor publications have over the last decade had local property, banks and commodities to the forefront of their minds.
These asset classes have enjoyed quite some success. However Australian investors are now way over-exposed to banking shares, mining shares and buy-to-let property.
Global investments and alternative asset classes have received much less media focus and therefore fund inflows.
6) Hindsight bias
The ability to view past losses through 20-20 hindsight can dangerously impact upon investors’ ability to learn from mistakes.
This tends to affect retail investors more than institutions which tend to have a more rigorous ‘inquest process’.
7) Avoiding regret bias
Investors large and small are prone to assign misfortunes to bad luck when investing in blue chip stocks.
This can lead to complacency that is at least as prevalent in institutions as amongst private investors – e.g. “no-one ever got fired for holding onto Australian insurers over the last decade….”
However retail investors are particularly prone to experiencing much greater regret when investing in less mainstream assets that perform poorly.
This perhaps accounts for retail investor’s excessively high concentration upon term deposits and blue chip equities.
It represents a challenge to those marketing funds in Australia that invest in smaller company equities, emerging market debt and alternative assets.
8) Recent bias
The rational retail investor (and advisor) should select a time horizon that aligns with life goals. The reality is that even for long-term retirement savings, selected investments are analysed over a much shorter time frame.
Some advisors are especially enthusiastic to recommend funds or SMAs that appear high in one and three year performance tables. Now that such data is freely available many self-directed investors are equally culpable of this habit.
This can lock the investor into the loop of investing in the trend or asset class that performed well over the previous period – leading to significant long-term under-performance.
An indicator of how behavioural finance impacts retail investors is that relatively few produce performance in excess of ETF post-fee returns.
9) Confirmation bias
An investor’s confidence grows as a successful investment reaches dizzier heights.
Meanwhile the media they consume is full of the happy story, with articles highlighting valid reasons why certain investments within the asset class are appreciating for entirely rational reasons.
This usually leads to an increased appetite for headlines and stories that align with the investor’s view, and the rejection of contrary views that are to be discounted.
Your blogger received a distinctly frosty reception at a recent Sydney dinner party when suggesting that buy-to-let property in certain nearby suburbs looked vulnerable to a price correction, suggesting some aversion to critical thinking.
10) Growth over value bias
Empirical data indicates that contrary to popular belief, value stocks out-perform growth stocks over the long-term.
According to Seawright2: ”We choose ideology over facts and stories over data.” In other words there is a behavioural bias towards unlimited upside over proven known factors.
This explains why managed funds that focus on growth are thought to be more easily marketable to Australian investors than are value funds.
Behavioural finance helps explain why investors, especially non-professionals, tend to invest excessively in the familiar, to avoid realising their losses and fail to learn from past errors.
It leads investors to establish undiversified portfolios that then suffer further from their poor decisions on market timing.
The way that behavioural finance impacts retail investors causes significant drag on long-term investment performance. This can have a huge effect on their lifestyles.
In the next blog post we will examine how investment managers of retail funds can help investors avoid behavioural finance pitfalls and find the “free lunches” that can help them reach their investment goals.
Do you have examples of how behavioural finance impacts retail investors in Australia?
We have created a concise twenty-step guide to how an investment manager can establish a profitable and sustainable direct retail funds business through an engaged customer strategy; please click here to download.
‘Business Man Making Money With Tablet Concept’ image courtesy of ratch0013 at FreeDigitalPhotos.net
‘The Anchor On Stone Background’ image courtesy of jk1991 at FreeDigitalPhotos.net
‘Regret Word Shows Wordclouds Repentant And Remorse’ image courtesy of Stuart Miles at FreeDigitalPhotos.net
1 Shefrin, H, 2007, “Behavioural Finance: Biases, Mean-Variance Returns and Risk Premiums,” Santa Clara University, http://www.cfapubs.org/doi/pdf/10.2469/cp.v24.n2.4700
2 Seawright, R.P, 2013, “Explaining the Value Premium,” https://rpseawright.wordpress.com/2013/04/25/explaining-the-value-premium/