Reprinted courtesy of the National Post
by Tom Bradley

Last week I was a panelist at Morningstar’s Executive Forum series. The topic was behavioral economics (BE). If economics is the dismal science, BE is its fun, social side. At its core is the premise that people behave irrationally in predictable ways. Believe it or not, we regularly make decisions that run counter to our best interests.

Today, BE is being embraced in all areas of business. Richard Thaler, one of its leading practitioners, was awarded a Nobel prize in Economics this year, and the latest book by best-selling author Michael Lewis (Moneyball, The Big Short) is about BE.

With no Ph.D or research papers to my name, I was the amateur on the panel. My role was to relate how our biases, or what I prefer to call challenges, impact investment outcomes. In other words, talk about where theory meets reality.

Our moderator asked which biases have the biggest impact. This is difficult because there are approximately a hundred behavioral challenges, and many can come into play on a single decision. I’ll focus on the ones I see most often.

Hindsight Bias

If I had to pick just one, this would be it. Hindsight bias refers to seeing past events as being more predictable than they actually were. For instance, there were clear signs that the 2008 financial crisis was coming or, perhaps, it was easy to see that Amazon was going to $1,000.

Playing mental games with the past sounds harmless, but unfortunately, it leads to the belief that market trends are predictable. If it was possible to do before, it must be possible going forward.

For me, hindsight bias has been the most damaging behavioral issue we’ve had since 2008. Too many Canadians missed the current bull market because they were basing their decisions for long-term portfolios (20, 30 or 40-year time horizons) on short-term market calls. Hindsight bias fed another bias, short-termism.

Herding Bias

There’s no doubt we take comfort from what others are doing. As they say, it’s warmest in the middle of the herd. Maybe it’s our chilly climate and open pastures, but Canadian investors are prone to herding. Riding the latest trend is the path of least resistance.

Consider the biggest market themes of the last two decades. Many investors ran with the herd on technology, gold, energy, foreign stocks only and then Canada only. In each case, their portfolios had minimal exposure at the beginning of the run and were loaded up at the end. Effectively buying high and selling low.

There are many other biases I could mention. For instance, our preference for avoiding losses over acquiring gains (loss aversion) tilts portfolios towards overly-cautious asset mixes. We tend to put undeserved faith in our own judgement when things are going well (overconfidence bias). And we tend to place a higher value on the stocks we hold compared to ones we don’t (endowment effect).

The Road to Rational

The first step in neutralizing our behavioral biases is being aware of them. One of my favourite books for doing this is ‘Predictably Irrational — The Hidden Forces That Shape Our Decisions’ by Dan Ariely.

The best all-purpose defense is diversification. A portfolio that is invested across different geographies, industries and asset types, provides a solid foundation from which to pursue specific themes and trends.

On that note, a good choice for many investors is a balanced fund. There’s evidence to suggest that the best way to avoid getting too short term, or cozying up to the herd, is to hold a fund that covers the waterfront, as opposed to building a portfolio using specialized funds.

Developing a routine is also useful. Regular, monthly contributions and/or a consistent date for re-balancing, takes the emotion out of the investment process. The more automatic, the better.

And when I let my guard down and start obsessing about the market, I remind myself of something Doug MacDonald once told me. Doug, who was one of the pioneers of financial planning in Canada, said, “It became much easier to do our job once we realized that nobody, including us, knows what is going to happen in the future.” Rational indeed.