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The 2010 Behavior Survey: Moderate Biases

Here's our attempt to connect behavioral finance theory with real investors.

Michael M. Pompian, 08/19/2010

This article is the third in a series examining the results of a practical application of behavioral finance survey that I recently did in partnership with MorningstarAdvisor.com (more details on the survey can be found in the original article).

It bears repeating that the population of survey takers in the Morningstar universe can be generally defined as "mostly male, mostly experienced [experienced having a double meaning here--experienced in the sense that they are not new to investing and experienced in the sense that that over half of the survey takers were older than 60], and mostly do-it-yourself" investors. What this means is that the majority of survey takers were very proactive, engaged and self-directed investors which, naturally, is only a subset of all investors. For simplicity, I will call the investors who took the survey "PEM" (proactive, experienced, and male) investors. It will be insightful for us to examine how prevalent each bias within the population of PEM investors. Why? Because we tend to think of investors older than 60 as those that should have a somewhat risk-averse posture toward their portfolios. Conventional wisdom suggests that more-risk-tolerant investors tend to have longer time horizons, meaning that they likely are younger. What we have in this survey are fairly risk-tolerant investors in the later stages of their lives. We do, however, have a subset of survey-takers who have lower risk tolerance. And even risk-tolerant investors, regardless of age, will have biases associated with conservative investors. We will study today how survey-takers answered questions related to biases of moderate investors, and I will offer some commentary about this data.

Biases of Moderate Investors
Recency Bias
Bias Type: Cognitive
Bias description: Recency bias is a predisposition for investors to recall and emphasize recent events and/or observations. They may extrapolate patterns where none exist. Some of these investors enter or hold on to investments when prices are peaking, which can end badly, with sharp price declines. Below is the survey question related to recency bias.
(View the related graphic here.)
Commentary: With nearly two thirds of investors answering this question in the affirmative, I would say this is what I would have expected. I doubt there is a single investor out there who hasn't bought into an overvalued market or overvalued investment--because it is simply human nature to want to "get in" to a rising sector during a bull market. Those who entered the housing market in 2007 for example either through direct real estate purchases or real estate stocks know how recency bias can be harmful.

Hindsight Bias
Bias Type: Cognitive
Bias Description: Moderate clients often lack independent thoughts about their investments and are susceptible to hindsight bias which occurs when an investor perceives investment outcomes as if they were predictable. The result of hindsight bias is that it gives investors a false sense of security when making investment decisions, emboldening them to take excessive risk without recognizing it. Below is the survey question related to hindsight bias.
(View the related graphic here.)
Commentary: I'm glad to see that at least 50% of the survey takers realize that investment outcomes are not predictable. In the end, investing is a probabilistic endeavor and those who believe that investment outcomes can be predicted need to reevaluate their thinking. The significance of this chart is high. Advisors need to manage the expectations of their clients in terms of how predictable their portfolios will perform from one year to the next, and even from one decade to the next. Who would have believed it if I told you in 2000 that the return on the S&P 500 would be approximately zero by the end of 2009?

Framing Bias
Bias Type: Cognitive
Bias Description: Framing bias is the tendency of investors to respond to situations differently based on the context in which a choice is presented (framed). Often, moderate investors focus too restrictively on one or two aspects of a situation, excluding other considerations. Below is the survey question related to framing bias.
(View the related graphic here.)
Commentary: This was actually somewhat of a trick question. Statistically speaking a three standard deviation event should happen approximately one in 100 years not one in 10 years..but perhaps because we've had such wild swings in market valuations over the past 10 years, investors are getting used to these events. In any case I was very impressed to see that such a high percentage of respondents said they would stick to their plan. This is good news for advisors.

Cognitive Dissonance Bias
Bias Type: Cognitive
Bias Description: In psychology, cognitions represent attitudes, emotions, beliefs or values. When multiple cognitions intersect--for example a person believing in something only to find out it is not true--people try to alleviate their discomfort by ignoring the truth and/or rationalizing their decisions. Investors who suffer from this bias may continue to invest in a security or fund they already own after it has gone down (average down) even when they know they should be judging the new investment with objectivity. Below is the survey question related to this bias.
 (View the related graphic here.)
Commentary: Given that such a high number of respondents chose the first answer, it's possible that this question could be interpreted in a different way than intended based on the bias description. Even so, since such a high number of respondents answered that they would buy more because it's cheaper should be somewhat of a yellow flag. And you know why. Just because something is cheap doesn't mean it's a good investment. Advisors need to be aware of their clients' tendency to want to buy cheaper when they have some familiarity with an investment.

Ambiguity Aversion Bias
Bias Type: Cognitive
Bias Description: Ambiguity aversion is a difficult bias to explain; therefore an example works best. Suppose a researcher asks you your prediction as to the outcome of an ambiguous situation: whether a certain sports team will win its upcoming game. Suppose the estimate given is 60% that the team wins. Further suppose the researcher presents you with a 50%/50% slot machine, which offers no ambiguity, and then asks which bet is preferable. If you are ambiguity-averse, you will likely choose the slot machine, even if you feel confident about the team winning. Below is the survey question related to ambiguity aversion bias.
(View the related graphic here.)
Commentary: There are some potential negatives and some potential positives associated with this response. One the negative side, what this chart tells me is that when PEM investors feel confident about or emotional about something (such as their favorite sports team), they will "go for it." This should raise a yellow flag for advisors. In the investing world, a client may have an affinity for an investment or feel confident about it and they may "go for it" which can be a losing strategy. On the positive side, what this tells me is that PEM investors have a tolerance for ambiguity which is good when it comes to investing in equities which, as we know, have a less than certain outcome. This makes the job of the advisor easier. You should probe your clients on this issue to see how they may respond to situations like this.

Hopefully you have learned something about how PEM investors are biased and how you might begin to think about counseling them when you encounter these biases. In next month's article, we will be reviewing how PEM investors answered questions related to biases growth oriented investors.

Michael M. Pompian, CFA, CFP, is an investment consultant to ultra-affluent clients and family offices and is based in St. Louis. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients.


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