Are your biases getting in the way of sound investment decisions?
When most people sit down with their financial planner for the first time, they complete a questionnaire designed to assess their risk tolerance, one of the fundamental tools used to develop a personalized investment strategy. Now, a University of Windsor researcher says financial planners must go beyond this traditional method to take into account how the presentation of financial information affects an individual's investment decisions.
Gokul Bhandari, an assistant professor at the Odette School of Business, says markets are driven largely by human psychology, and people bring all sorts of cognitive biases to the table when it comes to interpreting data and making decisions -- biases that could hamper their investment goals.
Risk tolerance not enough to guide investors
Bhandari, whose work was published in the journal "Decision Support Systems," studied 119 investors and discovered that individuals, regardless of their investment experience, demonstrate the influence of three cognitive biases when they process information; as a result, the majority make unwise decisions that don't jibe with their risk tolerance profiles.
In the web-based experiment, the researcher used computers to gather in-depth demographic information about the investor and his or her risk tolerance and then asked the investor to allocate $100,000 of pension money among different investment options. When people made biased decisions (often based on how the information was presented) that flew in the face of their profile and risk tolerance, the computer alerted them to the inconsistencies. "(As) they became aware of the inconsistency, it gave them the opportunity to reflect on their decision," says Bhandari, adding it led the majority of people to change their decision for the better.
Be aware of these three biases
In his efforts to assess how cognitive processes cause people to react to information, Bhandari determined the majority of bad investment decisions can be attributed to three types of information processing biases.
The first, which he calls framing, illustrates the different ways in which people value or perceive information based on how it's presented in terms of design or packaging. "Marketing is all based on framing, and we tend to overlook this (when it comes to investment decisions)," says Bhandari. Information can be presented in many different ways, and this can influence people's decisions: they might react favourably to one design and not to another. While this is OK when it comes to buying clothing, it's not a sound approach to financial planning.
The second element considered in the study is representativeness, which is linked to how people tend to pay more attention to striking information, which leads to dangerous assumptions when investing. Again, this often comes down to packaging and presenting the same information in different ways.
For example, if a year-over-year stock chart is designed to illustrate a dramatic rise in returns, people may become overconfident in that particular stock and believe it will continue to climb. However, if the chart illustrated the stock's growth on a month-by-month basis, the visual effect would not be as dramatic and people might be more realistic with their expectations. In addition, if information is presented in bullets, people tend to focus on that information and take it as a wider truth instead of delving deeper or seeing the big picture.
A third area of concern is ambiguity, which occurs when investors are expected to sift through incomplete, conflicting or excessive information. "Humans have limited information processing ability," says Bhandari, and as a result, they become frustrated. In such cases, people usually make the wrong investment decision or find themselves "mentally paralyzed" and unable to make any decisions.
Decision-support systems a valuable investment tool
Bhandari's study is part of his PhD and there are a number of points that investors and financial advisers can take away from it. The first is a general awareness that risk assessment is not a foolproof tool for devising investment strategies. The second is the value of computerized decision-support systems and that will alert investors to their own biases and prevent them from making bad decisions.
"Behaviour biases do exist, we cannot deny it," says Bhandari. However, his research shows that we can improve on or avoid their detrimental effects when it comes to investing.
"There's a lot of opportunity for innovation in their field," he adds, predicting that within five years, the paper-based questionnaire method of assessing risk and choosing investments will be replaced by computer systems designed to get to know individual investors and guide their decision making. "We can do better, and this is where the market will go," says Bhandari.
While he is already working on a prototype, he stresses this is still largely an academic experiment and the next step is to connect with financial advisers and get them on board. It's not that much of a stretch. Decision-support systems are already used by businesses and medical professionals when it comes to making an array of decisions. It's only a matter of time, says Bhandari, before people turn to computers to help make better decisions in all areas of life. "It's not science fiction. It's possible that technology can understand our emotions and translate that into better decision making."
Michelle Warren is a freelance writer living in Toronto.