Are Behavioural Biases Impacting your Financial Decision Making?

Author: Chris Wiens, MBA, Certified Financial Planner®

Are you afraid to fail or are you a risk-taker willing to assume risk of loss in order to realize a greater gain? Is one tendency more common than the other and why?

Increasing studies and research in the area of behavioural finance are providing more insight to these types of questions. This research seeks to identify the factors that influence and guide the approaches that people take to financial risk and reward.

Back in the late 1960s and early 1970s, two Israeli scientists, Daniel Kahneman and Amos Tversky, pioneered research in the area of behavioural finance. One of their early studies was in this area of risk. Interestingly, they discovered that people are, in general, willing to take a risk to avoid a loss but far less willing to take a risk to realize a gain.

Further, our perception of gains and losses is prone to the same bias. They found that people generally experience more pain (negative feeling) with a loss than they do joy (positive feeling) with an equal gain. Apparently, the joy of gaining $100 is less than the pain of losing $100.

Could this response be more than emotional, but neurological as well? Another recent study¹ published in Science Magazine demonstrated this. Volunteers engaged in a computer simulated betting game while wearing an electrode cap which recorded changes in brain electrical activity in response to winning and losing. Upon each bet made, the medial frontal cortex showed an increase in activity. However, the intriguing part was that the medial frontal negativity showed a larger dip after a loss than the rise in medial frontal positivity after a win. During a string of losses, negativity dipped lower with each event – each loss was compounded by the previous loss. The study showed that, neurologically speaking, the aversion to loss of a certain magnitude is greater than the attraction to gain of the same magnitude.

Loss aversion (also called Prospect Theory) is one of the biases that impacts our behaviour not only as investors, but as people. Perhaps you have experienced these emotions more acutely over the past eight months with the high level of volatility we have seen in the markets. Behavioural finance seeks to understand the impact of loss aversion and other personal biases on investors. The strategies you and your advisor may undertake to overcome the negative behaviours often associated with these biases might be to:

Focus on the Process
- Establish logical decision-making processes to guard against errors that a reactive approach may yield, which is prone to deceptive biases and emotional and social influences.
Prepare, Plan and Pre-Commit
- Ensure you have a comprehensive financial plan, commit to the implementation, and review regularly.

“Investing success doesn’t correlate with IQ after you’re above a score of 25. Once you have ordinary intelligence, then what you need is the temperament to control urges that get others into trouble.” – Warren Buffet

In addition to Loss Aversion/Prospect Theory, here are some other common biases that the study of behavioural finance has found:

Confirmation Bias – drawn to information that confirms one’s belief and ignores that which contradicts.
Herd Mentality – follow and copy what other people are doing
Mental Accounting – putting money into separate categories or accounts (mentally) based on source of money or intent of account
Self Attribution Bias – attribute good outcomes to one’s skill and bad outcomes to sheer luck
Scope Neglect – eg. saving $20 on small purchase valued differently than saving $20 on larger purchase
Hindsight Bias – misconception, after the fact, that one ‘always knew’ they were right.
Anchoring Bias – rely too much on pre-existing or first information they find when making decisions
Affect Bias – relying on good or bad feelings experienced in relation to a stimulus
Narrative Fallacy – allowing our preference for a good story to cloud facts
Framing Bias – decision based on the way information is presented instead of facts themselves

¹ https://science.sciencemag.org/content/295/5563/2279.abstract

Connect Wealth is an independent financial planning firm that offers holistic advice to clients based on their current goals and future aspirations. We use well-established workflows and cutting edge technology to maximize planning efficiencies while simplifying the process for clients. Learn how you can maximize your financial opportunities at www.connectwealth.ca

Saving For Retirement

What Are Your Options?
What is the best investment plan to use to save for retirement? It used to be fairly simple; the answer was maximizing your RRSP. Do you know what is the best strategy for your situation? Do you know what your options are?

Here is a basic overview:
1. Save – The first rule of thumb to be concerned about is that you are saving money for your future. Too many Canadians are spending all of what they earn and not putting away any money for their future. A good place to start is to aim at putting away 10% of what you make.

2. Tax Efficient – Ever since the launch of the TFSA, there has been a debate by financial professionals over which investment plan is more tax efficient to use, the RRSP or TFSA? My opinion is that it depends on your situation both now and in the future and should be looked at on a case-by-case basis to see what fits best. I would be cautious if a financial advisor is always only promoting one plan type over the other, both have their benefits. (For more info on TFSAs, see my article from Sept 2013 – http://jaybrecknell.ca/demystifying-tfsa/)

3. Business Owner – If you are a business owner the question can get even more complex as you have more options. Should you use your RRSP, TFSA or instead save your retirement funds in a holding company? Since corporate tax rates are at an all time low in Canada more business owners are saving corporately versus in a RRSP or TFSA. There can be many benefits to saving corporately as it can provide flexibility to the business owner. As this can be complex it needs to be put together by a professional that understands your corporate structure and the tax and legal rules that are involved.

As with any financial strategy we would recommend ensuring that you have your personal situation reviewed by a professional to make sure that is done in the best way possible. If you have any questions or would like your plan reviewed feel free to contact us.

Questions?

December 1, 2014/by Vince Olfert

Business Planning

Business Owners Fail To Plan

Prepare Your Business For Sale
Only 9% of business owners have a documented transition plan in place and yet 70% of small business owners plan to transition in the next 10 years*! As a financial planner I continue to meet business owners who are planning to sell or transition their company but they do not have a plan. Typically they are either unsure of the process, so they procrastinate or the business is their baby and they do not want to let it go. It is understandable that a major decision like this is hard to make, especially without someone to assist you.

When a business owner is considering selling here are some things to consider:

1. Don’t Leave the Party Last – You see this with professional athletes when they face the question of when to retire? In my opinion you are either growing your business or it is shrinking it, there is no standing still. A lot of business owners later in their career can get into maintenance mode, which usually means the business is starting to decrease in revenues. At first the revenues may hold but after a couple of years you typically see them start to decline. If you want to maximize your selling price and be attractive to potential buyers be careful to wait too long.

2. It Takes Time – Selling a business can take you longer than you think. You need to find the right candidate to take over your business. You are looking for an individual that is an entrepreneur; remember there are more employees in the world than business owners. Also, in most transitions the current owner is asked to stay with the company to assist with the passing of the reigns. You should plan for 1-2 years to sell. This means you should be creating a plan 5-7 years prior to your planned exit.

3. Change – Every industry is faced with changes due to technology, regulatory, competition, etc. If you owned a video or record store in the 80 or 90’s, when was the best time to get out? What if the technology that Google is working on to make it so that cars drive themselves eliminate car accidents in the future. Could that affect you if you own an auto body business? What changes face your business?

4. Financials – Often times the financial statements for a business are ignored until it is too late. Yet they will play a very important role in the sale of the business. You want to make sure that your financials present the best view of your company so that a potential buyer is enticed to make an offer.

There are many things to consider when selling a business. The first is to get a professional that can assist you with putting a plan together to ensure that you maximize the value, save tax, and control when and how you sell your business. As with any financial strategy we would recommend ensuring that you have your personal situation reviewed by a professional to make sure that is done in the best way possible. If you have any questions or would like your plan reviewed feel free to contact us.

Questions?

*Source – http://www.advocis.ca/Update2014/index.html

December 1, 2014/by Vince Olfert

Insurance, Personal Planning

Protecting Your Biggest Asset

The Most Overlooked Risk
What is your biggest asset? Most people might answer your house, boat, car, or investments. When in fact it is your income and your ability to earn a living.

When I review a person’s financial situation, one of the most common areas that is overlooked is to protect their ability to earn a living. Disability insurance is a critical part of a person’s risk management plan. When you think about all of the things that people have insurance for, cars, houses, electronics, death, etc. Unfortunately if you do not have an income all of these other areas fall apart.

When it comes to managing risk, a financial planner looks at two main factors:
1. Risk – what is the chance of this happening?
2. Impact – If it does happen, what is the potential damage?

As an example, the risk of a house fire is low but the damage it can cause financially is extreme. Hence why people buy home insurance.

The Risk Is High:
Did you know that 1 in 3 people, on average, will be disabled for 90 days or more at least once before they reach age 65?*

The Impact Can Be Severe:
How long could you survive for without your income? Most families could last maybe 4 to 6 months before they would have to start selling other assets such as investments or their home. How would you survive till age 65 and then into retirement?

The main way to manage this risk is to have long term disability insurance to protect yourself in case of an illness or injury.

Possible Options:
1. Canada Pension Plan – This will only pay for the most severe disabilities and the amount is small.
2. Worker Compensation – This only covers you if it is a work related injury.
3. Group Plan – This is how most Canadians are covered. IMPORTANT! You should have your coverage reviewed to make sure you are properly protected.
4. Individual Plan – You can purchase this through the major insurance carriers.

Key Facts:
• If you are an executive or earn over $80,000 per year and you have group coverage you should have it reviewed, as you may not be fully protected.
• If you have group coverage your plan definition typically will change after 2 years of being disabled. This can allow the insurance company to decline your coverage if your disability is not severe enough. This is done to keep your rates lower for your group plan. You can get individual insurance to protect against this.
• The definition of a disability policy is critical.
• Most disability insurance is designed to cover you till age 65; some may have only a 5-year benefit period.

Questions?

*Source – “A guide to disability insurance”. Canadian Life & Health Insurance Association

December 1, 2014/by Vince Olfert

Are Behavioural Biases Impacting your Financial Decision Making?

Author: Chris Wiens, MBA, Certified Financial Planner®

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