Behavioural finance and how it hits your bottom line

Glenn Freeman  |  28/06/2016Text size  Decrease  Increase  |  

Glenn Freeman: I'm Glenn Freeman for Morningstar Australia and I'm joined today by Simon Russell, founding director of Behavioral Finance Australia.

Simon, thanks for joining us.

Simon Russell: Pleasure to be with you.

Freeman: Now, Simon, how much do life experiences, upbringing and family impact our attitudes to money and to investing?

Russell: Well, how long have you got for an answer for that question, I guess. I mean, it's a very interesting and important question and has been looked at from the behavioural finance perspective.

One study, from memory, was looking at Sweden, for example, where you've got a lot of data that allows you to go and check whether your family circumstances then influence your financial decisions, or is it whether you're – you can check how you compare with your twin or how you compare with other people in your region.

So, when you can unpick some of those relationships, you can start to see, well, there is a role for genetics, for example.

Some of what I do will be similar to what my siblings do. There is a role for financial circumstance, so family circumstances, so that I will tend to do things that are similar to what my other siblings or other people who might have been adopted might have done, even if the genetics were different.

But certainly, then there's a big influence on our experiences, the individual circumstances, just the way information is framed, the choices that I'm given. So, it's quite complex.

I guess, there's a whole lot of different influences. And what we find is that it changes over time.

So, your family circumstances, as you might imagine, are more important to start with and your genetics, for example, might be more important for some of your early life financial choices.

But as you move further forward through your life your choices are more shaped by your subsequent experiences and other circumstances.

Freeman: And can different types of financial behaviour be learned and unlearned?

Russell: Well, I'd say yes, but with caveats and with difficulties.

So, some financial decision-making, what behavioral finance research and the underlying psychology and neuroscience shows, are often driven by subconscious effects or subconscious biases. So, in some ways, it's difficult to learn and unlearn aspects that are actually happening beyond our conscious awareness.

Having said that though, that's not everything.

We're not all obviously driven by subconscious sort of twitches and the like. Certainly, some things can be learned and the evidence shows that when you look at certain decision-making biases – so, for example, the disposition effect, which is the tendency of people to hold on to stocks that are falling and to sell the ones that have gone up – well, actually, that changes depending on the circumstances individually, it changes depending on, for example, their experience.

So, we do seem to be able to learn to overcome some things, but not perfectly, and not some things that perhaps we don't get the feedback for or perhaps our experience isn't allowing to overcome.

Freeman: Simon, one of the criticisms that is sometimes levelled at behavioural finance is that the approaches can sometimes be too broad to be directly actionable and measurable. What's your take on this?

Russell: Look, I would agree. That's what I tend to find in some of the popular sort of mainstream financial press.

And to be fair, I guess, if you're aiming at a broad audience and you want to get some punchy headlines out there, that's probably a good way to at least raise some awareness about the field.

But in another way, it's a bit disappointing, because a lot of the research is actually quite the reverse. It's not really actionable and unmeasurable.

It's actually based in controlled experiments or sort of systematic analysis of financial choices, which you can measure, you can connect it to the underlying psychology.

You connect it often to brain processes that can be measured through fMRI (functional magnetic resonance imaging) scans and the like. You can connect the psychology, the behaviour and then all the way through to financial outcomes.

So, if you can sort of empirically test and connect the dots, measure it along the way, and then think about, well, now we understand it, what can we do about influencing some of those things?

If you can measure and test it, well, really we should be able to actually move away from some of those sort of woolly concepts.

Freeman: In your new book Applying Behavioral Finance in Australia you outlined some examples of how overconfidence can lead to people trading too much and to some quite staggering results. Can you elaborate a bit on that for us?

Russell: Yes. We probably should start with overconfidence, and psychologists have defined overconfidence in a number of different ways. But one of the key ways is that we underestimate how much uncertainty there is in our decision making.

So, if I'm thinking about a stock, I'm thinking about what the possible range of outcomes might be in the future, well, I might have a valuation range, whether or not I make it explicit that I might have in my mind, there's a range of possible outcomes.

Now, if that's what I think of the possible outcomes, what the evidence shows is that actually my range is too narrow, often by a long way. So, what I think is, this actually might be a much broader range.

Now, if the range is broader, that changes my decisions. It means I'm less likely to trade on something if now there's a much broader range of possible outcomes, whether it might be high or low.

So, if we are less overconfident, we sort of see the real true nature of that uncertainty, we tend to trade less and that connects to financial outcomes.

So, it connects to tax outcomes for a start. If we're trading less frequently then we're less likely to incur capital gains tax if we're a tax-paying investor.

We're less likely to lose that 12-months capital gains tax discount. If we're holding on to – this disposition effect we just mentioned – if we're holding on to stocks that have gone down and selling our winners, we're less likely, if we're trading less, to be getting the capital gains tax impact from all those realised gains, but without offsetting losses and we're also less likely to be incurring the costs, the market impact costs, the buy/sell spreads which can be significant, particularly for larger investors.

So all that translates into dollars, whether there will be tax outcomes, or cost outcomes, or return outcomes in many cases.

In the book there is an example where an investor with $1 million, based on some simplifying assumptions and looking at different sort of trading frequencies actually over a period of 10 years, might be $200,000 worse off, just looking at the tax consequences.

That's a simplified example, but the evidence actually looks in quite some detail at broad scale studies of individual investors and looks at the high frequency traders tending to have lower returns than less frequent trading individuals.

And similarly, there's some evidence at an institutional fund manager level show that those that are trading less frequently and the lower turnover fund management products on average – this is not everything of course – but on average, tend to do better than the ones that have a higher trading frequency as well.

Freeman: Thanks very much for joining us, Simon.

Russell: Thank you very much for having me.

Freeman: I'm Glenn Freeman for Morningstar. Thanks for watching.

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