By Arnold Machel, CFP®
“…for you do not know which will succeed, whether this or that, or whether both will do equally well. “
Ecclesiastes 11:6 (NIV)
Imagine this. You receive a call offering you $200 to participate in a study just a block from your home and with a promise that it will not take more than half an hour. You agree and now you are here. Waiting. You haven’t received your $200 yet and you’re starting to get irritated that you’ve sat in the waiting room for 15 minutes already. So much for that half hour commitment.
Finally, your name is called. You are led into a room in which there are a table and a chair, and on the table are 3 padded envelopes labelled 1, 2 and 3. You are told that two of the envelopes contain $200 each and one of them contains $1,000. The padding makes it impossible to tell if one is thicker than the others, so at this point it’s just random. You pick number 2.
Here’s where things get tricky. Your patron (who, by the way, knows which envelope has the $1,000 in it) hands you envelope 2 (the one that you chose) and tells you he will take away one of the $200 envelopes and then provide you with an option. He picks up number 3 and opens it to show you the contents: $200. Now he asks, “Would you like to change your choice of envelope?” What should you do? Should you take number 1 instead? Does it matter?
The field of behavioral finance assists us in figuring out what most people will do… and why. It’s become a popular field of study in many prestigious schools (schools such as Harvard and the Wharton School of Economics) lately, because while it won’t tell us what one specific individual will do, it helps us predict what masses will do. Behavioral finance seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions. Those who study in this field look at common biases, such as…
- Anchoring (or Confirmation) Bias: First impressions are strong because we tend to selectively filter, paying more attention to information that supports our opinions while minimizing the rest. We often resort to preconceived opinions when encountering something new. An investor whose thinking is subject to confirmation bias would be more likely to see information that supports his or her original idea about an investment.
- Loss (or Regret) Aversion Bias: Loss aversion describes wanting to avoid the feeling of regret experienced after making a choice with a negative outcome. Investors who are influenced by anticipated regret take less risk because it lessens the potential for poor outcomes. It explains an investor's reluctance to sell losing investments to avoid confronting the fact that they have made poor decisions.
- Disposition Effect Bias: We tend to label investments as winners or losers. Disposition effect bias can lead an investor to hang onto an investment that no longer has any upside or to sell a winning investment too early to make up for previous losses.
- Hindsight Bias: This leads an investor to believe after the fact that the onset of a past event was predictable and completely obvious, whereas in fact the event could not have been reasonably predicted.
- Familiarity Bias: This occurs when investors have a preference for familiar or well-known investments despite the seemingly obvious gains from diversification. We may feel anxiety when diversifying investments between well known domestic securities and lesser known international securities, as well as between both familiar and unfamiliar stocks and bonds that are outside of our comfort zone. This can lead to suboptimal portfolios with a greater risk of losses.
- Self-attribution Bias: Investors who suffer from self-attribution bias tend to attribute successful outcomes to their own actions and bad outcomes to external factors. Self-attribution bias leads investors to become overconfident.
- Trend-chasing Bias: Investors often chase past performance in the mistaken belief that historical returns predict future investment performance. This tendency is complicated by the fact that some product issuers may increase advertising when past performance is high to attract new investors. Research demonstrates, however, that investors do not benefit because performance usually fails to persist in the future.
Back to our study. Looks like they are going to make that half hour commitment after all. All you need to do is make a simple decision. Should you change your choice? The answer is a definite and resounding yes. Believe it or not, the math is indisputable, but many people (even smart math geeks) would not make the switch. Why? Because for most of us the math is not immediately obvious and like most of the rest of the world we face some behavioural finance biases. In this case, we may be affected by anchoring, regret aversion, disposition effect, self-attribution and trend-chasing biases. Any or all of these could be enough to over-ride the math that is as definitive as 2 + 2 = 4.
How do you combat these biases? Sometimes wisdom and discernment and self-awareness are enough. Sometimes you need the help of a professional. Just be aware that like the title says: You Don’t Know What You Don’t Know, so if it’s available to you, seek professional help whenever you are unsure of which envelope to pick.
Still having trouble believing that you should switch? Math Forum has a great site that helps explain it. Check out the web site at http://mathforum.org/dr.math/faq/faq.monty.hall.html or try it out yourself.
Arnold Machel, CFP® lives, works and worships in the White Rock/South Surrey area. He attends Gracepoint Community Church where he serves on the Leadership Team. He is a Certified Financial Planner with IPC Investment Corporation and Visionvest Financial Planning & Services. Questions and comments can be directed to him at dr.rrsp@visionvest.ca or through his website at www.visionvest.ca. Please note that all comments are of a general nature and should not be relied upon as individual advice. While every attempt is made to ensure accuracy, facts and figures are not guaranteed.