The Chartered Financial Analyst (CFA) designation is often considered the highest distinction in the investment management profession. Consisting of 3 levels of exams, each one being a 6-hour exam that is held on one designated day in June set by the CFA Institute around the world (Level 1 also takes place one day in December). Level 1 and 2 exams are (apart from the Ethics section) overwhelmingly quantitative in nature and an extension of what we consider Traditional Finance so we’re talking a lot of calculations and rational theories. However, the Level 3 curriculum introduced a topic called Behavioral Finance that challenged that Traditional Finance narrative and it quickly became my favorite topic of the curriculum because it was something that I consistently related to in my 20 years of working with clients.
If I could define Traditional Finance and Behavioral Finance to my 10 year old daughter it would go something like this;
“Traditional Finance explains how investors ‘should’ behave based on rational theories while Behavioral Finance explains how investors ‘actually’ behave, which is rooted in psychology and therefore not always rational”.
I wanted to write about one component of Behavioral Finance, specifically the 6 Emotional Biases that occur among investors. Essentially these biases help explain why individuals will sometimes make investment decisions that can be deemed irrational and against Traditional Finance logic. Although there are other biases/reasons (i.e. Cognitive Biases), Emotional Biases are those that arise from impulse, intuition, feelings, and they result in sort of personal and perhaps un-rational decision making. The relevance in all of this is that if you or an investor is susceptible to one of these biases it can lead to sub optimal portfolios which may then lead to underperformance.
LOSERS: Acronyms can be a blessing when studying for a major exam and the 6 Emotional Biases had the perfect one termed; L.O.S.E.R.S. This article will go through each one as it relates to clients/investors and how investment professionals and advisor can help mitigate its impact.
L – Loss Aversion: Arises from the fact that an investor feels a greater emotional effect from a loss than an equal value in gain.
For example, the emotional anxiety experienced on a 20% loss will far outweigh the emotional pleasure experienced from a 20% gain. As a result, individuals may hold on to their losing stocks for too long (to avoid realizing a loss) and sell their winners too soon (to avoid the possibility of losing their profits). This combination may lead to an increase in portfolio risk, excessive trading and reduce upside potential. One way to mitigate this bias is to have a systematic investment approach that is based on Fundamental and/or Technical analysis.
O – Overconfidence: Is when an individual overestimates his/her level of knowledge or forecasting skill.
They will typically take credit for the positive results and fault outside factors for the failures. The consequences in this case is that it leads to an overconfidence in predictions, underestimates the risk and overestimates the return. This bias will lead investors to overemphasize their winning decisions and downplay their losing decisions. To correct for Overconfidence Bias, the investor should do a reality check of his/her portfolio’s performance by keeping detailed trade records including the motivation for the trade. A detailed review will allow the investor to understand the big picture and learn from the losing decisions.
S – Self Control Bias: Happens when an investor displays an inability to pursue long-term goals due to self control issues.
These individuals are typically more interested in short term small payoffs versus pursuing the prospect for a much bigger payoff in the long term. This can lead to a situation where they fail to meet the required wealth for their target investment horizon. This can lead them to taking excessive amounts of risk towards the end in order to “catch up” to their goal and time horizon. To correct for Self Control Bias, the investor should have an Investment Policy Statement along with a financial plan that can be reviewed regularly in order to keep the investor on track to achieving his long-term goals.
E – Endowment Bias: Typically occurs in inheritance cases; when an individual values an asset that they own as worth more than if they actually had to pay to acquire them.
For example, an individual inherits shares of the family business or shares of a stock that has been in the family for many years and feel they are worth more than their fair or market value. They often stick with these assets because of their comfort-ability and familiarity. A consequence of this bias leads to investors holding onto investments too long and having concentrated portfolios with a high level of risk. To correct for Endowment Bias, the advisor should ask the client if he was given an equivalent amount in cash, would he have purchased the same securities that he inherited. More often than not, the investor would have likely purchased some other securities if he had the cash. The advisor’s role then would be to persuade the client to gradually transition his portfolio from the endowed securities to the ones that he would have purchased had he had an equivalent amount in cash.
R – Regret Aversion Bias: Is when there’s a tendency of investors to do nothing due to fear of making the wrong decision.
For example an investor stayed out of the market and/or did not want to rebalance their portfolio during the 2008 market crash for the fear of making the wrong decision. Similarly, an investor may adopt a herd mentality and do what the majority is doing to avoid the regret of being the only one that made a bad decision. So if everybody bought shares of Google and the stock dropped it you won’t feel as bad because you’re not the only one. To mitigate this, the advisor or individual must educate themselves on benefits of a proper asset allocation, a diversified portfolio and rebalancing. A failure to do so can lead to portfolios that are either too conservative or too risky.
S – Status Quo Bias: Somewhat related to endowment bias and regret aversion, it’s an inclination to stay with the current investments due to indifference.
Essentially an emotional desire to do nothing or stay with the default choice rather than opting to make a new, possibly better choice for the long term. Consequently, the individual may end up holding a portfolio that is no longer suited to her changing risk tolerance, while at the same time miss the potential to earn a higher return by not switching to other securities. To correct for Status Quo Bias, an advisor should demonstrate what the outcome would be to the client’s portfolio in the long term if no changes are made at the current time. For example, the advisor may show that the returns generated by the existing mix may be insufficient to meet the client’s stated objectives.
When driving on the path of long term investing, emotional biases are the blind spots that advisors and client themselves should be aware of. Not recognizing them can easily jeopardize meeting the financial goals altogether. The toughest part about dealing with them is that unlike rational biases that can be overcome through education and logic, emotional biases are rooted in feelings and psychological factors that in some cases cannot be overcome and must be accommodated.
Islam teaches Muslims to be disciplined, humble and grateful for what we are given. Similarly, when it comes to investing if we lack self control, are arrogant and don’t value properly what we are given (endowment bias), it can cause a portfolio to suffer. At ShariaPortfolio, we keep aware of these behavioral traits that can potentially be harmful to a portfolio’s performance. Schedule your free consultation call today, call at (321) 275-5125 or send us an email at firstname.lastname@example.org.
Investing in securities involves risk, and there is always the potential of losing money when you invest in securities.
Halal compliant investments, diversification and asset allocation do not ensure a profit or protect against loss.
This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.